ETFs vs. Mutual Funds: Which Is Better for Young Investors?

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.

Understanding Investor Goals and Preferences

Before we dig into ETFs versus mutual funds, there's 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-advantage 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.

ETFs

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 1996 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.

Mutual Funds

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 Analyst (CFA), CFP, and founder 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.

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.

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.