ETFs vs. Mutual Funds: Which Is Better for Young Investors? (2024)

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.

Key Takeaways

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.

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 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.

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 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.

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.

	ETFs	Mutual Funds
Passive or Active Management	Both are available, but primarily passive	Both are available, but primarily active
Structure	Funds that purchase and manage portfolios of securities	Funds that purchase and manage portfolios of securities
Professionally managed	Yes	Yes
Diversification	Broad exposure to variety of assets/asset classes	Broad exposure to variety of assets/asset classes
Liquidity	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
Costs	May include operating expense ratio, broker's trade commissions, bid/ask spread	May include operating expense ratio, loads, 12b-1 fee
Expense Ratio	Usually lower than actively managed funds	Usually higher than passively managed funds
Pricing	Determined by market	Net asset value (NAV)
Tax Efficiency	Usually tax efficient due to less turnover and fewer capital gains	Not as tax efficient due to more turnover and greater capital gains
Automatic Investing	Not available	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.