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

It can be difficult for young investors to start investing. They may be dealing with limited funds, student loan debt or lack of knowledge about how investing in the stock market works. On top of that, they face an industry that’s more interested in advertising to them than educating them as to what may be the best options to consider.

By no means should that hold young investors back from getting into the market. Rather, they should educate themselves and find the best investment vehicle to suit their particular needs. With that in mind, many young investors will hear about exchange-traded funds (ETFs) and mutual funds and wonder which may be best. There is no simple answer to that question, although there are some things to keep in mind when deciding between the two. Here are some things to consider. (For more, see: Mutual Fund or ETF: Which is Right for You?)

ETFs are the new(er) kid on the investing block. They first started trading in 1993 and have grown in popularity since. There are many things to like about ETFs, such as:

• They are generally cheaper than their mutual fund sibling with an average expense ratio of 0.21% in 2017 versus 0.59% for mutual funds, according to Investment Company Institute (ICI) research.
• They are generally more passive and track an index rather than actively trading like a mutual fund.
• You can buy ETFs through virtually any online broker, whereas mutual funds aren’t always available through all brokers.
• Many online brokers now offer commission-free ETFs, regardless of account balance.

There are some other significant differences between ETFs and mutual funds, though the above list provides a good high-level view that will benefit most young investors. For most having a hard time meeting initial minimums for mutual funds, ETFs can be a great alternative. This is especially the case if they pursue a long-term buy-and-hold strategy of sticking to mainstream indices. When following a standard index, ETFs are also more tax efficient and more liquid than mutual funds. Again, this is great for the young investor focused on building wealth over the long-term. (For more, see: ETF Liquidity: Why it Matters.)

To say that an ETF is perfect for young investors is shortsighted. Nothing is perfect, and such is the case with ETFs. While cheaper expense ratios and less turnover are good, it’s not true of all ETFs. In fact, the ETF craze has led some to create ETFs that track obscure indices that often trade very infrequently. The commission-free ETFs mentioned prior can be good, but in some instances they’re lacking in solid index funds that track a known index.

Another potential drawback to an ETF is that it will do what the index it is tracking does. Brent D. Dickerson certified financial planner (CFP), founder of Trinity Wealth Management, says: "The drawback to an ETF is that it will do what the index it is tracking does. So, for example, if you invest in an ETF that tracks the S&P 500, if it loses 40% of its value, then so will the ETF. With a mutual fund, the manager is not typically invested in the exact same assets as the index… and so, there is a possibility of doing better than the ETF. The same holds true for up markets. If the index increases 40% so will the ETF. Actively managed mutual funds may see outperformance of the index, but this is never something that can be duplicated time and time again over long periods of time."

The final thing young investors should consider is how actively they plan to trade ETFs. Active trading will lead to an increase in their overall fees.

While not as hip as ETFs, mutual funds can be a great investment option for many young investors. They may not be available through all brokerages, but in most cases, you can purchase them directly from the given fund family. Even if you can purchase them through a broker it’s generally much cheaper to buy them directly through a fund family.

Most fund families also make it easy to drip money in on set intervals, which is a great feature for young investors trying to establish a consistent investing pattern. “For young investors who want to invest on their own, I think low-cost mutual funds are a slam dunk. It is just far easier and more efficient to implement the kind of automatic investing of $x a month that is most common for young investors with mutual funds. 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 lead advisor with Resource Planning Group. (For more, see: Mutual Funds: A Tutorial on the Basics.)

Finally, mutual funds are usually actively managed rather than passively tracking a single index. In certain instances this brings added value to a fund.

Mutual funds are more expensive, on average, than ETFs. As mentioned, the average expense ratio for ETFs is 0.21%. Mutual funds, on the other hand, average 0.59%, though many are above 1% due to things like 12b-1 fees, which essentially compensate advisors for selling a given fund.

Mutual funds are also generally actively managed. Active management is not a bad thing, per se, though it can bring added cost and tax situations for young investors they may not be expecting or know how to manage. Plus, there is the risk of underperforming the overall market. (For more, see: Mutual Funds: Don’t Overpay for Them.)

Lastly, many mutual funds have minimums to open an account. In many instances that may be $1,000 or $2,500, so you’re not able to invest in the given fund unless you have that amount of money to invest. For the young investor just starting out, this can hold them back when they otherwise could be investing in an ETF.

The question of whether an ETF or mutual fund is better for young investors misses the point to a certain extent. The more important point is to start investing to build wealth. The chosen investment vehicle is important, but indecision should not hold you back from starting your journey.