Exchange-Traded Funds (ETFs) vs. Closed-End Funds: An Overview
Investors have many 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) also have their merits.
Both ETFs and CEFs allow an investor to purchase shares of a professionally managed fund without needing a large initial investment, and both fund options are traded continuously through an exchange. However, ETFs and CEFs differ in terms of fees, fund transparency, and pricing on the open market.
Key Takeaways
- Both exchange-traded funds (ETFs) and closed-end funds (CEFs) are types of investment funds that invest in a variety of assets.
- ETFs are open-ended funds, meaning they can constantly take on new investors and as they do, the fund's assets grow.
- CEFs have a fixed number of shares that are offered through an IPO. After that, no new shares will be issued and the fund is "closed."
- Both ETF and CEF shares trade on an exchange throughout the day, with the price fluctuating based on supply and demand.
Exchange-Traded Fund (ETF)
An ETF is a pooled investment security. It functions similarly to a mutual fund, however, ETFs can be bought and sold on exchanges just like stocks. Mutual funds do not have this feature. This is what makes ETFs much simpler to invest in and is one of the reasons ETFs have gained in popularity since their emergence.
ETFs are primarily passively managed, meaning they track a specific benchmark, whether that be a stock index, a sector, or a specific asset. The SPDR S&P 500 ETF (SPY), for example, tracks the S&P 500. The iShares Semiconductor ETF (SOXX) tracks the semiconductor sector. Note that there are also actively managed ETFs.
ETFs can be bought and sold throughout the trading day like a stock, which gives ETFs the feature of increased liquidity. They need to be registered with the SEC and can be designed to track any benchmark the manager chooses. ETFs are usually low-cost, making them great investment choices for investors. The expense ratio is the primary fee investors should pay attention to for an ETF.
Most ETFs are open-ended funds, meaning that any number of shares can be issued, allowing for the assets under management (AUM) of an ETF to continuously grow. There is no limit to how many people can invest in an ETF.
ETFs can be bought easily through a brokerage account just like a stock. Investors who already have online brokerage accounts, for example, can search for the ticker for a specific ETF and purchase it as they would a stock.
The tracking error of a fund will inform you how successfully it tracks its benchmark.
Closed-End Fund (CEF)
A CEF is a type of mutual fund that issues a fixed number of shares. These shares are issued through an initial public offering (IPO) and can then trade on the secondary market. No new shares are issued and, therefore, the fund will always have a specific amount of capital invested.
The remaining features of a CEF are similar to that of other investment funds. CEFs have a manager that invests the capital based on a specific strategy, shares trade throughout the day, CEFs need to be registered with the SEC, and they charge investors an expense ratio for the management of the fund.
One of the most common types of CEFs is a municipal bond fund.
Key Differences
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 the 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 the sponsor company provides.
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.
What Is an Example of an ETF?
Some popular ETFs include SPDR S&P 500 ETF (SPY), Vanguard S&P 500 ETF (VOO), iShares 20+ Year Treasury Bond ETF (TLT), iShares Russell 2000 ETF (IWM), VanEck Gold Miners ETF (GDX), and iShares Core MSCI Emerging Markets ETF (IEMG).
Which Is Better, an ETF or a Mutual Fund?
Whether an ETF or a mutual fund is better will depend on the investor and their profile. ETFs are generally cheaper because they are primarily passively managed, and easier to buy and sell because they are traded throughout the day on an exchange, making them more liquid. Depending on the mutual fund, the returns may be better if it is an actively managed fund, but the risk is higher.
What Is the Difference Between an ETF and a Stock?
A stock is ownership in a publicly traded company. An ETF is an ownership in an investment fund that buys and sells stocks or other assets. While an individual who purchases a stock owns a portion of that company, an investor in a stock ETF does not own shares of that company. An ETF invests in many stocks so there is more diversification by investing in a fund than the outright ownership of one stock.
The Bottom Line
Both ETFs and CEFs can be good investment options for investors, with the choice depending on the investor's financial profile, such as their risk tolerance, budget, and investment objectives. ETFs have lower expense ratios as they are mainly passively managed. CEFs, while costing more because they are mainly actively managed, can trade at a discount to their NAV.
Investors looking for standard, safer investment strategies would do well choosing an ETF, whereas investors looking for alpha returns may do better with a CEF.
