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, 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.

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, 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. 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 circumstances, 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.

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.

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.