Comparing ETFs To Closed-end Funds
There are significant differences between a traditional Exchange-Traded fund (ETF) and an actively managed Closed-End fund which can be confusing to the average investor. There are certain basic features that one should understand before utilizing these solutions as investment options.
The first thing an investor should understand is what an ETF actually is and how it’s structured. An ETF, simply stated, is a mutual fund that tracks a specific market index, such as the S&P 500 index. ETF’s have been created to provide an investment option for just about every major market index that exists. For those investors who wish to take a passive approach to investing, ETFs are a low cost solution. In the case of the S&P 500 index for example, once can purchase the iShares ETF (IVV) with an annual expense ratio of 0.07%. When compared to the average cost of an actively managed mutual fund, which is closer to 1%, they seem very attractive from an expense ratio perspective.
Part of the reason ETF investing has become so popular is the low internal expenses. Yet index funds have been around for some time. So why the explosion in the ETF market? One reason is liquidity. An ETF trades like a stock on an exchange between investors and can be traded throughout the day. This allows investors much greater flexibility. Whereas, a traditional index mutual fund sells shares directly from the fund company to the shareholders, then subsequently buys the shares back when you wish to sell. This in turns requires the investor to wait until the 4PM closing price to exit or enter the market. And investor looking to trade intraday, or take a short position is not afforded this opportunity in a traditional index mutual fund.
What about a closed-end fund?
The difference here is that while a closed-end fund trades on an exchange much like an ETF, it is vastly different in many ways. The ability to trade on an exchange allows for the same degree of liquidity when it comes to intra-day trading. Yet these solutions can be quite misleading to the novice investor. A closed-end fund actually has a fund manager much like a traditional actively-managed fund. This means that the low cost components traditionally associated with ETF’s do not exist. In fact, in many cases closed-end funds are even more expensive than a traditional mutual fund. The investor is essentially paying the higher fees for fund management and internal trading costs and gaining only intra-day liquidity. The reason is there is actually a premium you must pay for the liquidity. Keep in mind that mutual fund companies earn more as their assets grow. Assets grow based on both positive market performance, as well as new money being invested into a fund.
Since a closed-end fund issues an initial number of shares at the public offering, those shares are often finite. They are then traded amongst individual investors. So a major revenue source (the ability to sell new shares) is eliminated. Many investors are unaware of this and mistakenly associate these types of closed-end funds with the low cost ETF market place.
So if intra-day trading is not a priority to you and you seek active management, would you be better off with a traditional mutual fund? With a closed-end fund it’s also important to note that it is quite common for these investments to trade at a fairly significant premium or discount to their net asset value (NAV). Simply put, when you add up the value of the underlying investments bought by the fund manager, it may be quite different than what the fund is trading for in the market place. Some can trade as much as 20% below or above its NAV. While this may create an opportunity for you to buy securities at a steep discount, you may also be substantially overpaying for them as well. In a traditional open-ended mutual fund, the funds closing price at 4pm always reflects the precise NAV without any premium or discount. It is important to be aware of these differences in pricing when looking at an investment in a closed-end fund.
Lastly, a major component to closed-end funds that is vastly different from an ETF is its ability to use leverage in the fund. Essentially the fund managers can borrow on margin to purchase a larger portfolio to try and increase dividend yield and net return. This however creates not only greater expenses, but also potentially much greater volatility. Ironically many clients who would never take out a loan, borrow on margin to purchase an investment. These investors are doing so unwittingly with closed-end fund holdings in their portfolio. In many cases the effective leverage in a closed-end funds portfolio can be as high as 50%-60%. Ultimately, this excess leverage has the effect of amplifying the returns whether positive or negative, which translates into greater long term volatility. An excellent resource to research such positions should you own them would be www.cefconnect.com.
Closed-end funds are also commonly offered as new issues by commissioned sales brokers who receive substantial markups in order to bring them to market. It is even more common for them to decline almost immediately after the investor received new shares of this new issue. When such a price change takes place, the market is effectively adjusting the price of the security for the compensation paid to the sales representative almost immediately.
In general, there is good reason to be a strong advocate for low cost ETF investing to gain exposure to the equity markets. However, when navigating investment options, less sophisticated investors would be well advised to avoid exposure to the increased risk and expenses commonly associated within the closed-end investment funds. When evaluating any investment vehicle it is important to examine all the pros and cons associated with each opportunity.