To date, we have compared exchange traded funds (ETFs) with open-end mutual funds.
Today we will take a quick look at ETFs versus closed-end investment funds (CEFs). I shall not delve too deeply into CEFs as they have become a very small percent of the investment market versus open-end mutual funds and ETFs.
As at September 2018, Morningstar lists 630 CEFs covering all asset classes in its CEF Quickrank screener. Morningstar’s Mutual Fund Quickrank lists 26,974 funds (although this includes multiple share classes for each fund) and 2229 ETFs. Most investors will happily go through life never trading a CEF. So not a focal point in this series.
ETFs Are Much Like CEFs
ETFs are very similar to CEFs.
Both have a limited number of outstanding shares; trade directly between investors continuously throughout the day on authorized exchanges; (normally) require investors to pay brokerage fees, but no loads, when buying or selling shares; can be bought on margin; determine share price by investor demand, not the net asset value (NAV) of the ETF or CEF.
For the most part, ETFs and CEFs are the same investment vehicle.
But do not confuse them when investing.
There are differences between the two and these can impact your investment.
ETFs Often Have Lower Expense Ratios
As with open-end mutual funds, ETFs often have lower annual expense ratios than CEFs.
Most CEFs are actively managed. As a result, their expenses will typically be higher than a passively managed ETF in the same asset class. This may be enhanced in CEFs that utilize debt to leverage portfolios. Interest costs must also be factored into total annual expenses.
However, with an ever increasing number of actively managed and niche ETFs, that may increase annual ETF ratios.
Always look for apples to apples comparisons when assessing potential investments. A plain-vanilla S&P 500 Index ETF should have a lower expense ratio than an actively managed U.S. small cap focussed CEF. Whereas, an actively managed small cap ETF’s expenses may be more in line with that of a similar CEF.
As we discussed in our annual expense review, larger companies may have economies of scale that reduce expenses on a per unit basis.
ETFs Tend to Trade at their NAV
I wrote above that price is determined by investor demand (and supply of available shares) for ETFs and CEFs.
But now I am saying that ETFs trade at their NAV.
What gives?
Well, both statements are true.
ETFs are traded between investors who determine the market price based on demand and supply of shares issued by the fund company. However, the way in which ETFs are typically traded by institutional investors results in their share price normally reflecting the fund’s NAV.
Without getting too detailed, institutional investors use arbitrage techniques to try and profit on differences between the market value of the ETF and and the actual components of the index being tracked. The intense competition ensures that price variances between ETF and the index will be negligible, meaning that the ETF will normally trade at its NAV.
This institutional arbitrage is not present in CEFs. Without this mechanism, there can be material fluctuations between the NAV of a CEF and its market capitalization based on investor demand and available supply.
CEFs may trade at either premiums (market value is greater than NAV) or discounts (market value is less than NAV). There are a variety of factors as to why, including: assets within the portfolio; number of shares outstanding; liquidity; market efficiency; expectation of management’s ability to outperform.
Some investors seek out CEFs that trade at discounts. They believe that they are buying an asset at a discount to its intrinsic value (or, at least the current net asset value of the company). The expectation is that the share price will revert back to NAV, creating a profit for the investor.
Other investors do not mind paying a premium. Perhaps they believe that the management team will outperform in asset selection and that is worth something. Or maybe the assets in which the fund invests cannot be accessed directly by the investor (e.g., private equity).
ETFs May Be More Liquid
Not always the case, but ETFs are often more liquid than CEFs.
Per Morningstar data, there are 11 CEFs that are part of the U.S. Large Blend Equity market. Only 4 of the 11 have a market value over USD 500 million. The largest, Gabelli Dividend & Income (GDV), is at USD 1.96 billion.
Decent size funds, but a far cry from ETFs tracking the S&P 500 index which reflects U.S Large Blend stocks. The SPDR® S&P 500 ETF (SPY) has a market value of USD 271 billion. The iShares Core S&P 500 ETF (IVV) USD 165 billion. The Vanguard S&P 500 ETF (VOO) USD 104 billion.
There is much less capitalization (and likely liquidity) with the CEFs.
To buy or sell a CEF (or ETF) you need to find another investor. With open-end mutual funds, you trade with the fund company. Assuming the company is solvent, liquidity is not an issue. But if a CEF has limited shares outstanding, it may be difficult to buy or sell.
If considering CEFs (or even smaller ETFs), review the average daily trading volume to get an idea as to how liquid your investment may be. For example, the SPDR® S&P 500 ETF (SPY) has an average daily trading volume of 59.3 million. The Gabelli Dividend & Income (GDV) CEF only trades 0.11 million per day. The limited volume may require investors to pay more to buy and accept less to divest their shares. Especially in a rapidly moving market.
Remember, the less liquidity, the greater the potential costs in your portfolio.
Conclusion
CEFs can be useful investments.
I personally prefer CEFs that trade at discounts to their portfolio’s NAV. My hope is that the CEF share price will revert to its NAV, or even a premium, thereby giving me more return than simply from the investment returns within the fund itself.
But for the most part, I do not recommend CEFs. For investors maintaining a passive investment strategy, CEF costs are usually too high relative to ETFs and open-end index mutual funds.
I also prefer ETFs or open-end mutual funds that trade close to, or at, their NAV. Having to assess the potential for discounts and premiums is another factor that complicates analysis and can potentially impair my returns.
Finally, I prefer the generally greater liquidity in ETFs and open-end mutual funds.
An exception is for markets that may not have ETFs or open-end index funds available. This used to be an issue in certain countries or asset classes. However, over time this is becoming less of a problem as more and more index funds and ETFs are created.
