From the June 2008 issue of Research Magazine • Subscribe!

ETFs vs. Closed-End Funds

While both exchange-traded funds (ETFs) and closed-end funds (CEFs)share many of the same features, they have important differences. Understanding these differences can help you to make informed investment decisions.

Investment Strategies

The bulk of ETFs are tied to indexes, whereas almost all closed-end funds are actively managed. With the exception of leveraged funds, most ETFs do not use futures or options to magnify their gains. A good portion of the closed-end fund market is composed of funds that use leverage.

Fund Transparency and NAV

Because fund components are pegged to an index, the transparency of ETF holdings is excellent. Investors can easily identify the underlying stocks, bonds, or commodities of a fund by consulting the index provider or fund sponsor. CEFs have less transparency because their portfolios are actively managed, but changes in holdings are usually disclosed quarterly.

ETFs generally trade close to their net asset value (NAV) and it's rare to see popular ETFs trading at a large premium or discount to their NAV. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This process keeps ETF share prices in line with the NAV of the underlying index or basket of securities.

In contrast, CEFs are more likely to trade at a premium or discount to their NAV. The premium is usually a result of greater demand (more buyers than sellers) for a fund's shares, whereas a discount would imply less demand (more sellers than buyers). The NAV is calculated by subtracting a fund's liabilities from its total assets and dividing the figure by the number of shares outstanding.

Fees

The expense ratios of ETFs are generally lower versus CEFs. Since ETFs are indexed portfolios, the cost of managing them is less compared to actively managed portfolios.

Also, ETFs often have lower internal trading costs versus actively managed funds, due to their low portfolio turnover. The ETF cost savings can be significant, especially for long-term investors.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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