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, exchange-traded funds (ETFs) or mutual funds? That depends on a number of factors. They include how much a young investor has to invest, how actively involved they want to be with their investments, 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) than investing in individual securities.

ETFs are a newer option for investors and they were originally known for having far lower fees than comparable mutual funds. That gap has closed in recent years as mutual funds work to attract new investors.

Key Takeaways

  • Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index.
  • ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
  • ETFs are bought and sold on an exchange throughout the day while mutual funds can be bought or sold only once a day at the latest closing price.
  • Many online brokers offer commission-free ETFs regardless of the size of the account. Some mutual funds 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 rapidly in popularity since then.

You can buy ETFs through virtually any online broker, while not all mutual funds are 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, most are passive investments that mimic the contents of an index. The return should be nearly identical to the return of the index.

As such, they can be appropriate for investors with a long-term buy-and-hold investment strategy who prefer passive over active management.

ETFs are generally lower than those that are charged by actively managed mutual funds because their managers are merely mimicking the contents of an index rather than making regular buy and sell decisions,

For some investors, the design of a passive ETF is a negative. The stated purpose of the ETF is not to beat an index but to match it. Investors who want to maximize their returns and beat the indices are not best served by ETFs.

Mutual Funds

While not as hip as ETFs, mutual funds can be a great investment option. You can purchase them directly from the company that issues the fund.

Most companies 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. 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 or emerging markets. In such circ*mstances, active managers try to take advantage of price inefficiencies to boost the fund's returns.

Bear in mind that active management results in added costs and an annual performance that may fall 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 depending on the fund. Extremely popular funds are often closed to new investors because their vast size can make them inefficient. Rest assured, comparable funds are available from the company or its competitors.

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.

ETFsMutual Funds
Passive or Active ManagementBoth are available, but primarily passiveBoth are available, but primarily active
StructureFunds that purchase and manage portfolios of securitiesFunds that purchase and manage portfolios of securities
Professionally managedYesYes
DiversificationBroad exposure to variety of assets/asset classesBroad exposure to variety of assets/asset classes
LiquidityGenerally, highly liquid due to availability on exchanges but some ETFs can be thinly tradedGenerally, highly liquid but can take several days to receive proceeds from sales
How To TradeBuy and sell shares at different prices on an exchange any time during open hoursBuy and sell once a day at end of day, at one price
Minimum Required InvestmentLimited to cost of shares and how many are boughtVaries, e.g., from $0 to $500 to $3,000
CostsMay include operating expense ratio, broker's trade commissions, bid/ask spreadMay include operating expense ratio, loads, 12b-1 fee
Expense RatioUsually lower than actively managed fundsUsually higher than passively managed funds
PricingDetermined by marketNet asset value (NAV)
Tax EfficiencyUsually tax efficient due to less turnover and fewer capital gainsNot as tax efficient due to more turnover and greater capital gains
Automatic InvestingNot availableYes, 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 want 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 by having your money actively managed.
  • 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 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 many not setting a required minimum investment.

Are ETFs Good for First-Time Investors?

ETFs can be a great choice for first-time investors of any age. Most ETFs are funds that pool investor money and then use it to buy individual securities, matching the listings in an index. The returns will be near-identical to the index or other indicator.

ETFs are professionally managed and traded throughout the day on exchanges. They don't require a minimum investment because they trade as shares.

A huge variety is available, including ETFs that track the major indexes and specialized indexes for sectors, industries, and regions. The biggest ETF of all is the S&P 500 (SPY) Index.

What Are Two Disadvantages of ETFs?

A passively managed ETF is designed to track an index, not beat it. If your goal is to beat the index, the ETF isn't for you. You need to choose an actively managed fund or pick your own stocks.

Another disadvantage of some funds, particularly highly specialized ones, is low trading volume. This results in wider bid-ask spreads, meaning you may not be able to buy or sell shares at the price you expect. Wide bid-ask spreads can also represent a hidden cost that you may not realize exists. It's a good idea to check on trading volume before you decide to buy a particular ETF.

The Bottom Line

For young investors, ETFs and mutual funds can offer tremendous investment opportunities. Which of the two is the best choice depends on the individual investor's financial goals, investing style, and overall strategy for reaching their financial goals.

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 want 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.

Article Sources

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.

  1. State Street Global Advisors SPDR. "SPY: The Original S&P 500 ETF."

  2. Vanguard. “ETFs vs. Mutual Funds: A Comparison.”

  3. Fidelity. “ETFs vs. Mutual Funds: Cost Comparison.”

  4. State Street Global Advisors. "SPDR S&P 500 ETF Trust."

  5. State Street Global Advisors. “ETF Liquidity: Master the Mechanics of ETF Trading.” Page 3.

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

FAQs

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

ETFs can be more tax-efficient

tax-efficient
What Is Tax Efficiency? Tax efficiency is when an individual or business pays the least amount of taxes required by law. A financial decision is said to be tax-efficient if the tax outcome is lower than an alternative financial structure that achieves the same end.
https://www.investopedia.com › terms › tax-efficiency
than actively managed funds due to their lower turnover and fewer transactions that produce capital gains. ETFs are bought and sold on an exchange throughout the day while mutual funds can be bought or sold only once a day at the latest closing price.

Is it better to invest in ETF or mutual funds? ›

The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.

Are ETFs good for young investors? ›

Key Takeaways. Exchange-traded funds offer investment opportunities for young people with relatively small amounts of capital and a rudimentary knowledge of how investing works. There are over 3,000 U.S.-based ETFs to choose from, which allows investors to participate in a wide variety of different markets.

Are mutual funds good for young investors? ›

Short-term financial markets swing up and down way more than long-term markets. When you start investing in top mutual funds from a early age, it gives your investment time to transform itself into a bigger corpus. Over a longer period, you can change your investment strategy basis your financial plans.

What could be an advantage of ETFs over mutual funds? ›

ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Why are ETFs more risky than mutual funds? ›

While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.

What is the best thing to invest in when your young? ›

Fixed income. If you're a more risk-averse investor, fixed-income investments such as bonds, money-market funds or high-yield savings accounts can allow you to ease your way into the investment landscape. Fixed-income securities are generally less risky than stocks, though you'll also earn lower returns.

What is the safest investment for young people? ›

Money market funds, savings accounts, and short-term CDs can all provide safety and liquidity for your idle cash. The amount you keep in these investments will depend on your financial situation but most experts recommend keeping enough to cover at least three to six months of living expenses in an emergency fund.

Is it smart to only invest in ETFs? ›

ETFs make a great pick for many investors who are starting out as well as for those who simply don't want to do all the legwork required to own individual stocks. Though it's possible to find the big winners among individual stocks, you have strong odds of doing well consistently with ETFs.

Why should young people invest in mutual funds? ›

The younger you start, the more time your money has to grow through the power of compounding. Essentially, even small amounts invested in mutual funds can yield potentially reasonable returns over a period of time. So, imagine being in your early 20s with a considerable investment portfolio already up and running!

Are mutual funds smart for young people? ›

Rather than starting their investing journey with a handful of individual stocks, young people should focus on building a diversified portfolio using low-cost mutual funds and exchange-traded funds, Benz says.

What are the five cons of a mutual fund? ›

Potential Cons
  • High fees. Mutual funds have expenses, typically ranging between 0.50% to 1%, which pay for management and other costs to operate the fund. ...
  • Market risk. Just as with stocks and bonds, mutual funds generally have market risk, meaning that prices can fluctuate up and down. ...
  • Manager risk. ...
  • Tax inefficiency.
Oct 6, 2023

Why not buy ETFs? ›

Market risk

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

Should I switch from mutual funds to ETFs? ›

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

Who should invest in ETFs? ›

They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks. The cost to own an ETF may be lower than the cost to buy a diversified selection of individual stocks, too.

Are ETFs better for taxes than mutual funds? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Do you pay taxes on ETFs if you don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Why are ETFs so much cheaper than mutual funds? ›

The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.

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