What's the difference between exchange traded funds (ETFs) and closed-end funds?

Investors have a number of options available to them when it comes to investing in pooled funds. While mutual funds offer the largest array of choices and are most popular among individual investors, exchange-traded funds (ETFs) and closed-end funds (CEFs) have their merits as well. Both ETFs and CEFs allow an investor to purchase shares of a professionally managed fund without the need for a large initial investment, and both fund options are traded continuously through an exchange. However, ETFs and CEFs are different in terms of fees, fund transparency and pricing on the open market.

Fees and Expense Ratio Differences

All pooled investment options have associated expense ratios that cover the costs necessary to manage and distribute the funds. The expense ratios assessed on ETFs are often much lower than those applied to CEFs due to the nature of management of the underlying securities. ETFs are indexed portfolios; they are created to track the performance of a specific index, such as the S&P 500. An ETF manager purchases shares of the securities to mimic how they are weighted on the tracked exchange, and changes are made only when companies are added or removed from that specific exchange. This passive management approach keeps expense ratios on ETFs low.

Although CEFs are structured and listed on an exchange like ETFs, fund managers in the CEF market hone in on specific industries, sectors or regions of the world, and they actively trade the underlying securities to generate returns. Because of this active management style, expense ratios in CEFs are often much higher than they are in ETFs. Expense ratios and other fees charged to investors can be found within an ETF or CEF prospectus provided by the sponsor company.

Fund Transparency Differences

The greatest difference between ETFs and CEFs is how transparent each fund is to the investor. ETFs are highly transparent because ETF fund managers simply purchase securities that are listed on a specific index. Stocks, bonds and commodities held in an ETF can be quickly and easily identified by reviewing the index to which the fund is linked. However, the underlying securities held within a CEF are not as easy to find because they are actively managed and more frequently traded.

Pricing Differences

ETFs and CEFs also differ in how they are priced and sold to investors. ETFs are priced at or near the net asset value (NAV) of the index to which they are linked or the underlying basket of securities held within the fund. CEFs trade at a discount or a premium to their NAVs based on the demand from investors. Premiums on CEFs are the result of a greater number of buyers than sellers in the market, while a discount results from more sellers than buyers. Both ETFs and CEFs trade on established exchanges on the secondary market, such as the Nasdaq and the New York Stock Exchange.

Advisor Insight

Thomas M Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp, Hilton Head, SC

CEFs issue a fixed number of shares through an initial public offering. Thereafter, they can, and often do, trade at a price different than their NAV, depending on the secondary market demand.

ETFs can create or redeem shares continuously through an Authorized Participant, usually a large financial institution; so shares usually trade close to the NAV.

Management: ETFs are mostly passive, so they incur few trading fees. CEFs have higher trading costs, because the frequency of purchases and sales is greater.

Taxes: If an ETF investor wishes to redeem shares, the ETF doesn't sell any stock in the portfolio. Instead it offers "in-kind redemptions," which typically don’t limit capital gains. In contrast, CEFs do sell underlying shares, creating capital gains that are passed on to the investor.

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