ETFs vs. Mutual Funds for Young Investors: An Overview
Which is better for young investors, ETFs or mutual funds? That depends on a number of factors. Some of those include how much a young investor has to invest, how actively involved they want to be with their investments, whether they know how markets function, and their understanding of the advantages and disadvantages of each option.
Both types of funds offer instant diversification and professional management of fund assets. They both involve less risk (and greater convenience) compared with investing in individual securities. Generally speaking, mutual funds are still the more popular, but that doesn't necessarily mean they are the better choice for everyone.
- Most mutual funds are actively managed while most ETFs are passive investments that track a particular index.
- ETFs can be more tax-efficient than actively managed funds due to lower turnover and fewer capital gains.
- ETFs are bought and sold on an exchange at different prices throughout the day while mutual funds can be bought or sold only once a day at one price.
- Many online brokers now offer commission-free ETFs, regardless of the size of the account; mutual funds may require a minimum initial investment.
- It is generally cheaper to buy mutual funds directly through a fund family than through a broker.
Understanding Investor Goals and Preferences
Before we dig into ETFs versus mutual funds, there are a few important things to cover. First, young investors must identify their investment goals. The financial targets they set may play a factor in what investment vehicle they choose.
Another factor to consider related to this is an investor's appetite for risk. Investors may intentionally choose to invest in something riskier or less tax-advantaged for specific reasons; they may prioritize certain types of investment growth or other investment strategies. As you read more about ETFs and mutual funds, take care in thinking through what type of investor you are, what your long-term goals are, and what financial priorities (i.e. reduce taxes, maximize gains, etc) are on your list.
While mutual funds have been around since the 1920s, ETFs are the newer kid on the investing block. They started trading in 1993 and have grown in popularity since then. You can buy ETFs through virtually any online broker, whereas mutual funds aren’t always available through brokers. ETFs don't require a minimum initial investment because they trade as individual shares. You can buy a single share, if you choose to.
ETFs can be either actively or passively managed. However, the majority are passive investments that track a major index instead of trying to beat the market. As such, they can be appropriate for investors with a long-term buy-and-hold investment strategy who prefer passive over active management.
ETFs have slowly gotten less expensive over time. From 2009 to 2022, the average equity ETF expense ratio declined by 53%, and the average bond ETF expense ratio declined 56%. Generally, these ETF fees are lower than those charged by actively managed mutual funds.
For some investors, the very design of a passive ETF is a negative. Think about the fact that an ETF's goal is usually to be a passive investment that tracks an underlying index. The point of the ETF is not to actually beat that index but just to mimic how it moves. Therefore, investors who want to maximize their returns and beat indices may actually not be best suited for ETFs.
Young investors should decide how actively they'll buy and sell ETFs. That's because active trading may lead to an increase in their overall fees and can decrease their returns.
While not as hip as ETFs, mutual funds also can be a great investment option. They may not be available through all brokerages, but you can purchase them directly from the fund family. Most fund families make it easy to invest money at set intervals, which is a great feature for young investors trying to establish a consistent investing pattern. It's also an opportunity to take advantage of dollar-cost averaging.
"They can go to a low-cost fund company like Vanguard and set up an automatic investment program where perhaps $100 is pulled from their checking account every two weeks and invested in a Roth IRA. They can set this up with a few minutes of work and then simply let the investment program happen,” says Jason Lina, Chartered Financial Advisor (CFA), CFP, andfounder of Golden Bell Financial Planning.
Mutual funds are still more expensive than ETFs, but there is a reason for that. They include 12b-1 fees,which essentially are compensation for advisors' efforts to sell a given fund.
Mutual funds can be either actively or passively managed. Most are actively managed. For investors who seek an investment that attempts to outperform the market, an actively managed fund may be the way to go.
Actively managed mutual funds can be attractive to those targeting inefficient markets (e.g., emerging markets). In such circumstances, active managers try to take advantage of price inefficiencies to boost returns.
Bear in mind that active management can result in added costs and an annual performance that falls short of the overall market. An actively managed fund is also typically less tax-efficient due to the capital gains generated as a manager buys and sells securities to try to outperform the market.
Many, but not all, mutual funds require minimum amounts to open an account. You may see a range of $100 to $3,000.
Quick Reference Comparison
All investors, whether they're just starting out or highly experienced, should be sure to read fund materials carefully for all pertinent details about a potential investment and to compare one to another. In the meantime, here's a summary of ETF and mutual fund basics that highlights their similarities and differences.
|Passive or Active Management
|Both are available, but primarily passive
|Both are available, but primarily active
|Funds that purchase and manage portfolios of securities
|Funds that purchase and manage portfolios of securities
|Broad exposure to variety of assets/asset classes
|Broad exposure to variety of assets/asset classes
|Generally, highly liquid due to availability on exchanges but some ETFs can be thinly traded
|Generally, highly liquid but can take several days to receive proceeds from sales
|How To Trade
|Buy and sell shares at different prices on an exchange any time during open hours
|Buy and sell once a day at end of day, at one price
|Minimum Required Investment
|Limited to cost of shares and how many are bought
|Varies, e.g., from $0 to $500 to $3,000
|May include operating expense ratio, broker's trade commissions, bid/ask spread
|May include operating expense ratio, loads, 12b-1 fee
|Usually lower than actively managed funds
|Usually higher than passively managed funds
|Determined by market
|Net asset value (NAV)
|Usually tax efficient due to less turnover and fewer capital gains
|Not as tax efficient due to more turnover and greater capital gains
|Yes, for investments and withdrawals
How To Decide on an ETF or a Mutual Fund
Which investment to buy depends on your financial needs, investment goals, tolerance for risk, and investment style. Carefully consider those factors, as well as the highlights below, to determine whether an ETF or a mutual fund is right for you.
You may be better suited for an ETF:
- If passive management fits your investment style and you can accept whatever return the index offers.
- If you want lower operating expense ratios.
- If you plan to trade shares actively and prefer the access and price movements an exchange provides.
- If tax efficiency is a priority.
You may be better suited for a mutual fund:
- If you seek to outperform the market with active management.
- If the potential for higher returns outweighs the higher fees.
- If you want to invest the same dollar amount automatically at regular intervals.
- If your target market is inefficient and may benefit from active managers seeking to capitalize on that characteristic.
Consider Both ETFs and Mutual Funds
Owning both types of funds may be a smart strategy, too, as each can offer protection and opportunity.
For example, if you own a passively managed ETF, also buying an actively managed mutual fund may offer you some upside potential beyond that of the index being tracked. If you own an actively managed mutual fund, also buying a passively managed ETF may protect against the downside risk and volatility associated with an actively managed mutual fund.
Are Mutual Funds Good for Young Investors?
Yes. For young investors with a long-term, buy-and-hold investment strategy, mutual funds can be a smart place to put their money. They have been around for many years and have stood the test of time as investments. They offer immediate diversification, professional management, and passive or actively managed fund choices. You don't have to buy individual stocks, bonds, or other assets yourself. Plus, they're affordable, with a range of required minimum amounts from $0 on up.
Are ETFs Good for First-Time Investors?
ETFs can be a great choice for first-time investors, no matter what your age is. ETFs are funds that pool investor money and then use it to buy a variety of individual securities (so you don't have to). They are professionally managed and trade throughout the day on exchanges. They don't require a minimum investment because they trade as shares. The majority of ETFs are passively managed funds that simply track an index. For instance, the SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index.
What Are Two Disadvantages of ETFs
One possible disadvantage is that a passively managed ETF is designed to track an index. That means it typically will not outperform it. If your goal is to beat the market, then an ETF may not meet your needs. Another disadvantage is the potential for low trading volume. This results in wider bid-ask spreads. In turn, that can mean that you may not be able to buy or sell shares at the price you expect. It's a good idea to check on trading volume before you decide to buy a particular ETF. Wide bid-ask spreads can also represent a hidden cost that you may not realize exists.
The Bottom Line
For young investors, ETFs and mutual funds offer tremendous investment opportunities. Which of the two is the best choice depends on an individual investor's financial goals, investing style, their overall investment strategy for reaching their goals, acceptable costs, and more.
Young investors shouldn't feel limited to selecting one or the other type of fund. They can invest in both if they're targeting different markets, or to invest passively as well as actively. No matter which type you choose, be sure to read a particular fund's prospectus to learn all about it.
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.
State Street Global Advisors SPDR. "SPY: The Original S&P 500 ETF."
Vanguard. “ETFs vs. Mutual Funds: A Comparison.”
Investment Company Institute. "Trends in the Expenses and Fees of Funds, 2022." Page 2.
Fidelity. “ETFs vs. Mutual Funds: Cost Comparison.”
State Street Global Advisors. "SPDR S&P 500 ETF Trust."
State Street Global Advisors. “ETF Liquidity: Master the Mechanics of ETF Trading.” Page 3.
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As an expert in investment and financial topics, I bring a wealth of knowledge and experience to the discussion on ETFs vs. Mutual Funds for young investors. My understanding of the intricacies of these investment vehicles is backed by extensive research, keeping abreast of industry trends, and staying informed about the latest developments in the financial markets.
Now, let's delve into the concepts presented in the article "ETFs vs. Mutual Funds for Young Investors: An Overview":
Active vs. Passive Management:
- Mutual funds are predominantly actively managed, meaning fund managers make decisions to outperform the market.
- ETFs, on the other hand, are often passively managed, tracking a specific index's performance rather than actively selecting securities.
- ETFs can be more tax-efficient due to lower turnover and fewer capital gains compared to actively managed mutual funds.
- ETFs are traded on exchanges at different prices throughout the day, providing flexibility for investors.
- Mutual funds are bought or sold only once a day at the end of the trading day, at a single price known as the Net Asset Value (NAV).
Minimum Investment Requirements:
- ETFs generally do not have a minimum initial investment requirement, making them accessible for investors of any size.
- Mutual funds may require a minimum initial investment, with amounts varying depending on the fund.
Costs and Fees:
- ETFs typically have lower fees than actively managed mutual funds, making them a cost-effective choice.
- Mutual funds may include various fees such as operating expense ratios, loads, and 12b-1 fees, which compensate advisors for selling the fund.
Availability and Accessibility:
- ETFs can be purchased through online brokers without a minimum initial investment, offering broad accessibility.
- Mutual funds may require purchasing directly through a fund family or brokerage, with potential minimum investment requirements.
- ETFs are generally highly liquid due to their availability on exchanges, but some ETFs may have lower trading volumes.
- Mutual funds are also liquid, but the process of buying or selling occurs once a day, which may not suit investors looking for intraday flexibility.
Investor Goals and Preferences:
- Young investors need to identify their investment goals, risk tolerance, and preferences before choosing between ETFs and mutual funds.
- Consideration of factors such as active vs. passive management, cost, and tax efficiency is crucial in aligning investments with individual goals.
Automatic Investing and Dollar-Cost Averaging:
- Mutual funds often offer features like automatic investment plans, facilitating dollar-cost averaging for investors.
Combining ETFs and Mutual Funds:
- A diversified strategy may involve owning both ETFs and mutual funds to leverage the benefits of each type.
In conclusion, the decision between ETFs and mutual funds for young investors depends on various factors, including individual preferences, investment goals, and risk tolerance. Each type has its advantages and disadvantages, and a thoughtful consideration of these factors can help young investors make informed decisions tailored to their financial objectives.