ETFs vs. Closed-End Funds: Which One Is For You?

Today’s investors spend billions of dollars and conduct hours of research every day to look for valuable assets that will give them attractive returns. While both Closed-end funds (CEFs) and Exchange-Traded Funds (ETFs) are popular financial products that can be purchased directly from exchanges, there is debate around ETFs vs Closed-end funds on which one of them makes a better investment idea. It is important that investors know the advantages of both kinds of funds, so that they can make better decisions.

While a sound investment decision heavily depends on what an investor’s goal is and how much risk they will take, there are other factors that also need to be considered. ETFs attract a lot of investors because they carry lower fees. Most ETFs also follow the general market trend. This makes investors feel an ETF is a good long-term investment opportunity than a managed mutual fund.

CEFs have a higher risk profile because they carry a fixed amount of stocks and are only available for trading over a short period. These funds can be bought from secondary markets as well at either a premium or a discount. They also carry higher fees when compared to ETFs.

This article will spell out some pros and cons of both types of funds.

The Popular ETFs Are Passive Funds

There are hundreds of thousands of ETFs that mostly track a major index in any market, such as the S&P 500 or the Dow Jones. For example, an ETF that follows S&P 500 will hold stocks that belong to that index and will move in the direction of the bellwether U.S. index itself. It is very rare that an ETF would move against the general trend of the index that it is observing. ETFs also do not trade in the individual shares that are part of them. Any loss or gain that is seen in trading ETFs are due to market conditions and the fund never rebalances its holdings. The only time an ETF shifts balance is when a new asset is added or an existing one is removed from the fund.

This kind of asset management within ETFs makes them passive funds, meaning they only conduct few trades in a day’s session than both stocks and mutual funds. This makes the cost of operating an ETF lower, and the expense ratio, which includes the fees that investors pay to fund managers, is also low. Investors can read an ETFs prospectus for details of its expense ratio before making an investment decision regarding the fund. ^[2]

For a U.S. investor, ETFs also present a great tax-saving alternative to regular mutual funds and stocks. Passive ETFs do not have regular capital-gains dividends or distributions. This makes them have lower taxation risks when compared to other kinds of funds, including CEFs, and other assets.

ETFs are an investor’s delight in terms of transparency because the fund managers who operate them just need to buy assets that are already part of a specific index. This means investors can be confident that the securities they hold when purchasing an ETF carries the same risk-reward profile that the security would carry in the open market. This kind of transparency makes an ETF a great investment option for new investors and institutional investors alike.

CEFs Are Actively Managed Funds

Closed-end funds (CEFs), usually contain a small portfolio of securities, whether they are equities, debt, or any other asset class, of a specific sector, market, or country. a higher risk and higher expense ratios than ETFs, which make them more expensive to purchase.

CEFs, unlike their passive cousins the ETFs, are bought and sold at either higher than the market value of their underlying securities (premium), or lower than that (discount). Therefore, the net asset value (NAV) of a CEF is not a very good pointer of its performance. The value of a CEF only depends on investor demand and fund supply. If there is a selling pressure among investors of the CEF, the fund will trade at a discount, and it will trade at a premium in case of a buying pressure. This means a CEF’s price could be substantially higher or lower than the value of its underlying assets. For example, the share price of a stock held in an equity CEF could be higher or lower than the stock’s market price quoted on the exchange.

Since most CEFs trade at a discount, investors bet on the probability that the net asset value of the fund grows, narrowing the gap between the market value of the underlying assets and the price at which the CEF was purchased. The greater the difference between the discount of the CEF and the current market price of the assets, the higher the likelihood that the discount will reduce to the fund’s one-year average. However, this is not a sure shot thing since market volatility could make these discounts and premiums unpredictable.

CEFs also could make use of leverage, borrowing money to purchase underlying assets. This raises yields, but it also equally increases their risk. Such a risk-reward profile makes CEFs an attractive investment opportunity for serious investors, including the big institutional investors and retail investors alike.

These funds have lower transparency since the assets are actively managed and constantly traded. Fund managers can add and remove any security they feel fits the CEFs return goals and this can be done frequently throughout the trading cycle of the CEF. This increases the risk profile of the fund. Today’s financial markets offer various choices for different investor goals. Whether investors pick ETFs or CEFs, they will have to conduct thorough research and read the relevant documents before deciding. Sound financial decisions require constant planning and no investment option will assure returns. Both CEFs and ETFs will provide attractive returns if investors study their features before investing. However, more choices make it easier for investors since they have a range of options to pick from.