It’s vital for traders to understand the key differences between closed-end funds (CEFs) and exchange-traded funds (ETFs). Each has its pros and cons. This knowledge can translate into making informed investment decisions.
A standard misunderstanding is that a closed-end fund (CEF) is a traditional mutual fund or an exchange-traded fund (ETF). A closed-end fund is not a traditional mutual fund that is closed to new traders. And even though CEF shares trade on an exchange, they are not exchange-traded funds (ETFs).
A closed-end fund (CEF) or closed-ended fund is a combined investment model based on issuing a specified quantity of shares that are not redeemable from the fund. Unlike open-end funds, new shares in a closed-end fund are not created by managers to satisfy demand from traders. Rather, the shares can be purchased and sold only in the market, which is the original design of the mutual fund, which predates open-end mutual funds but offers the similar actively-managed pooled investments.
An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, just like stocks. An ETF holds assets such as stocks, commodities, or bonds as well as generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally take place. Most ETFs track an index, such as a stock index or bond index. ETFs may be interesting as investments because of their low costs, tax efficiency, and stock-like features.
The following are some of the differences between Closed-End Funds and Exchange Traded Funds:
ETFs are fully transparent, with holdings disclosed on a daily basis. Investors can easily identify the underlying stocks, bonds, or commodities of a fund by consulting the index provider or fund sponsor. With CEFs, selected portfolio details, including holdings, are often only disclosed on a monthly, quarterly or semiannual basis.
The costs of the CEFs are higher as compared to the costs of ETFs, because ETFs are indexed portfolios, and the cost of controlling these portfolios is less than actively managed portfolios. Besides, the internal trading cost of actively managed portfolios is higher than the internal trading cost of ETFs, because they have a low portfolio turnover. All in all, investors can save a lot if they invest in ETFs compared to CEFs, particularly if they are planning long-term investments.
Neither investment is better nor worse compared to the other. They are simply just different. Acquiring several investment options is a key factor in free and fair capital markets.
Net Asset Value (NAV)
ETFs generally trade close to their net asset value (NAV). It’s exceptional to notice ETFs trading at a large premium or discount to their NAV, however, it can happen. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This approach maintains 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 often a result of greater demand (more buyers than sellers) for a fund’s shares, whereas a discount might indicate less demand (more sellers than buyers). The NAV is computed by subtracting a fund’s liabilities from its total assets and dividing the total by the number of shares outstanding.