The Difference Between ETFs and Closed-End Funds

I have found over the years that many people, including financial advisors, do not understand the difference between exchange-traded funds (ETFs) and closed-end funds (CEFs). I believe that is because there are many similarities. But they also have very subtle yet distinct differences.

The Differences

One distinct difference is how the shares are issued and what the share price trades on the exchange. Closed-end funds issue a fixed number of shares to investors through an initial public offering (IPO). After the IPO they also can, and often do, trade at a price different than their net asset value (NAV). The price depends on supply and demand. If more people want to own the CEF than shares are available that could drive the market price above the NAV. Additionally, the reverse can occur. (For more, see: Open Your Eyes to Closed-End Funds.)

ETFs can create or redeem shares continuously through an authorized participant (AP) which is usually a large financial institution. As a result of the ETF’s ability to issue or redeem shares at any time, the underlying index price usually trades close to the NAV especially when it is a larger ETF like the ones that track the S&P 500 or similar popular index. This structure also creates a difference in the tax ramifications of each. When an ETF investor sells the shares of their ETF the manager is transferring the shares to someone else without creating a capital gain. CEFs create capital when an investor sells because the underlying shares need to be sold in order to give money to the seller. Any capital gains are passed on to investors at the end of every year.

Style Drift

One of the most distinct and obvious differences is the investment strategy and what we call “style drift” of each. ETFs are mostly passive. This means the investments are added based on a specific index strategy such as mentioned previously, the stocks listed in the S&P 500 Index. The shares and percentages owned of the underlying companies in the ETF equal those listed in the S&P 500 Index. Since an ETF follows a specific and preordained index, the ability for the manager to "drift" from this index is extremely difficult because the only time the manager is buying and selling securities is when the corresponding index removes and/or adds a company.

Closed-end funds are typically actively managed. This means the investments are chosen by a professional portfolio manager based on an investment strategy determined by the portfolio manager - not a widely followed index. The portfolio manager will buy and sell stocks depending on whether she believes they will outperform other shares. This discretion allows the possibility for the manager to stray from the original stated investment objective over time. If done correctly, an investor can benefit from this discretion. If done incorrectly, it can hurt an investor.

Transparency

The transparency of each is also a big differentiator. Since ETFs follow a specific index of securities (especially the larger ETFs) such as the S&P 500 where the components are known, the securities owned in the ETF are also known and published on a daily basis. ETFs usually do not use leverage, however some leveraged ETFs are available so please do your due diligence before investing. (For related reading, see: Right Fund for You: Closed End or Open End Fund?)

CEFs have securities being bought and sold at various times and amounts. As a result, the securities and percentage of holdings will vary over time. Closed-end funds are required to disclose their positions on a quarterly basis not daily. CEFs can and do use leverage. If the manager makes the right investments, it can enhance the investor's return significantly. However, the opposite can occur as well.

Fees and Expenses

The expenses incurred with each investment also can be different.

ETFs have lower trading expenses since the amount of companies' shares being bought and sold are limited to only the instances when the index adds or removes a company. This limits the trading costs. Also, since the investment strategy is usually passive the management fee typically is lower.

CEFs can have higher internal trading fees because the frequency of purchases and sales are usually higher, which increases the trading costs. Additionally, the portfolio manager is actively making decisions on which shares to buy and sell. Therefore, the management fee is typically higher.

Neither investment is better nor worse than the other. They are simply just different. Having multiple investment choices is a key element in free and fair capital markets. The important point here is that you understand the differences in the investment choices and that you choose the one that best suits your strategies and goals. Otherwise, you could be stuck with an investment that does not suit your intended result. (For more, see: The Complete Guide to Closed-end and Open-end Funds.)

 

Nothing contained in this publication is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Registered Representatives offer securities, insurance and advisory services offered through Aegis Capital Corp, member FINRA/SIPC. No investment strategy or program can guarantee a profit or protect against loss.