It's important for investors to understand the key differences between closed-end funds (CEFs) and exchange-traded funds (ETFs). Each has its advantages and disadvantages. This knowledge can translate into making informed investment decisions. Let's focus on the key points.
Fees
The expense ratios of ETFs are generally lower versus CEFs. Since ETFs are indexed portfolios, the cost of managing them is less compared to actively managed portfolios. Also, ETFs often have lower internal trading costs versus actively managed funds, due to their low portfolio turnover. The ETF cost savings can be significant, especially for long-term investors. Investing in both ETFs and CEFs will usually result in brokerage commissions. Information on specific fees, charges, and expenses is obtained in the fund prospectus.
Fund Transparency and NAV
Because fund components are pegged to an index, the transparency of ETF holdings is excellent. Investors can easily identify the underlying stocks, bonds, or commodities of a fund by consulting the index provider or fund sponsor. CEFs have less transparency because their portfolios are actively managed, but holdings can be uncovered by viewing quarterly or semiannually fund disclosures.
ETFs generally trade close to their net asset value (NAV). It’s rare to see ETFs trading at a large premium or discount to their NAV, but it can happen. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This process keeps ETF share prices closely hinged to the NAV of the underlying index or basket of securities.
By contrast, CEFs are more likely to trade at a premium or discount to their NAV. The premium is usually a result of greater demand (more buyers than sellers) for a fund’s shares, whereas a discount would imply less demand (more sellers than buyers). The NAV is calculated by subtracting a fund’s liabilities from its total assets and dividing the figure by the number of shares outstanding.
Style Drift and Leverage
Active CEFs are more susceptible to style drift versus index ETFs. Style drift is common with actively managed portfolios as money managers will sometimes divert from their original investment strategy. On the other hand, ETFs are generally insulated from style drift because a portfolio manager's freedom to hand pick securities outside the scope of an index is limited.
Many CEFs are leveraged, which magnifies the fluctuations of the NAV. If portfolio managers are correct about their selections, leverage is beneficial. At the opposite spectrum, poor investment decisions in a leveraged portfolio can be damaging. ETFs do not currently use leverage as part of their investment strategy, but this could change in the future. |
