ETF Education

ETFs vs. Closed-End Funds: Which Are Better for You?

ETFs are popular because they avoid discounts and premiums to NAV.

by David Kathman, CFA, Morningstar, 11/30/05

Dear Analyst,

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

Sam G.

Some firms out there would have you believe exchange-traded funds and closed-end funds are the same thing. Don't buy it.

Though there are some key similarities between ETFs and closed-end funds, there are some crucial differences. Understanding these differences can make you a better investor and help ensure that you choose the type of fund that's right for you.

How They're Similar?
Both ETFs and closed-end funds represent portfolios of securities (stocks, bonds, cash, etc.), just like open-end mutual funds. These portfolios can represent many different styles and combinations of asset classes, also like open-end mutual funds. There are ETFs and closed-end funds representing all the areas of the domestic-equity style box, as well as many foreign markets, many specific sectors (such as telecommunications), and various types of bonds. However, the distribution of the two types of funds among categories is rather different; whereas almost half of closed-end funds are bond funds, there are currently only a handful of bond ETFs.

Another similarity between ETFs and closed-end funds--and a key way they differ from open-end mutual funds--is that they are traded on an exchange. About three quarters of ETFs are traded on the American Stock Exchange (though iShares plans to move the listings of 81of its ETFs to the New York Stock Exchange or ArcaEx by 2007), while most closed-end funds are traded on the New York Stock Exchange. That means you can sell them short, buy them on margin, or do anything else you could do with a stock. At least, that's true in theory; in practice, many ETFs and closed-end funds are so thinly traded that it may be hard to find shares to borrow in order to sell them short.

Closed-end funds and ETFs share at least one advantage over conventional mutual funds due to their exchange listings. Because individual investors buy their shares in the secondary market instead of directly from the fund, closed-end fund and ETF managers don't need to hold cash or sell securities to meet sudden redemption requests from panicky shareholders or market-timers, nor can they be forced to invest vast new inflows of cash in a market that already seems pricey.

However, the fact that these funds are traded on an exchange also means that you have to pay brokerage commissions every time you buy or sell them, on top of whatever fees the funds charge. That means that they're not good for investors looking to do a significant amount of trading, or planning to buy more shares on a regular basis for dollar-cost averaging purposes. Some ETFs have recently tried to make dollar-cost averaging more feasible, but in general, anyone wishing to make regular additions to their investments will find open-end funds a cheaper option.

And How They're Different
The most obvious difference between ETFs and closed-end funds is cost. The average ETF in Morningstar's database has an expense ratio of 0.43%, while the average closed-end fund has an expense ratio of 1.27%. Why the discrepancy? It's mainly due to the fact that all ETFs are index funds, whereas most closed-end funds are actively managed. Actively managed funds cost more in general, because they require analysts and other kinds of research.

The reason there are no actively managed ETFs has to do with another key difference between ETFs and closed-end funds--namely how their shares are issued. A closed-end fund issues a set number of shares in an initial public offering, just like a stock, and it only issues more shares if it makes a secondary offering, also like a stock. After the IPO, the fund's shares can only be traded on the secondary market.

Because there are a set number of shares to go around, there can be a difference--either a discount or a premium--between the market price of a closed-end fund and the net asset value (NAV) of the securities in its portfolio. For example, as of Aug. 31, 2005, closed-end Spain Fund SNF traded at a 26.3% premium to its NAV, while Brazil Fund BZF traded at a 7.5% discount to its NAV.

ETFs, on the other hand, are designed to avoid such discounts and premiums as much as possible. With most ETFs, large investors called "authorized participants" can buy or redeem shares directly from the fund company, but only in blocks of 50,000 shares, which they then break up and sell on the open market to retail investors. Furthermore, when these authorized participants redeem one of these 50,000-share blocks, they get not cash, but the equivalent value in the underlying stocks. That means that the fund's holdings will always be known, unlike in open-end mutual funds, which have to disclose their holdings only once a quarter. Such transparency is possible and often desirable for index funds, but is virtually unheard of in actively managed funds.

Such "in-kind" transactions result in an arbitrage mechanism that keeps the ETF's market price from deviating too far from the value of its underlying securities. If the ETF shares trade at a discount, the authorized participants can trade the cheaper ETF shares for the more valuable stocks; if the ETF shares trade at a premium to their NAV, the authorized participants can trade the cheaper stocks for the more valuable ETF shares. The process actually can be quite a bit more complicated than this simple example, but you get the picture. This mechanism isn't perfect, so there can still be differences, but nothing like the double-digit discounts and premiums one often finds with closed-end funds.

There are other differences. Closed-end funds have been around longer. The oldest ETF was born in 1993, while the eldest closed-end fund predates The Great Depression and 1929 stock market crash.

Index ETFs also just try to match the returns of their benchmarks, which commonly focus on large, frequently traded stocks. Many closed-end funds, however, engage in more esoteric strategies. They often dabble in illiquid securities that can be hard to sell in a pinch. Many closed-end funds also use leverage; which means they invest with borrowed money. That pumps up the funds' income, but it also increases the offerings' volatility and therefore risk. When interest rates fall, the returns on leveraged closed-end bond funds are superior. When interest rates rise, leveraged bond funds get slammed.

Pluses and Minuses
There are advantages and disadvantages to each type of investment. If you buy a closed-end fund at a significant discount to its NAV, and that discount narrows or becomes a premium in a rally, then you'll make extra gains that you wouldn't get in an equivalent ETF or open-end fund. On the other hand, the discount could persist or even get worse, which isn't likely to sit well with shareholders. In fact, one of the factors in the explosive growth of ETFs in recent years was shareholder dissatisfaction over closed-end fund discounts.