ETFs Versus Closed-End Funds

Previously we compared exchange traded funds (ETFs) with open-end mutual funds.

Today we will take a look at ETFs versus closed-end funds (CEFs).  

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 Have Lower Expense Ratios

As with open-end mutual funds, ETFs have lower total expense ratios (TER) than CEFs.

Most, if not all, CEFs are actively managed. As a result, their TERs will be higher than a passively managed ETF.

Reviewing Morningstar data as at November 22, 2010 for U.S. domestic stock CEFs we see some interesting numbers. Selecting the 5 largest CEFs listed in this category (I am assuming that the larger funds will be better able to spread costs, resulting in lower TERs), we find:

DNP Select Income (DNP) has a market capitalization of USD 2.4 billion and an adjusted TER of 2.49%.

Kayne Anderson MLP (KYN) has a market capitalization of USD 1.9 billion and an adjusted TER of 2.50%.

Eaton Vance Tax-Managed Divrs Equity Inc (ETY) has a market capitalization of USD 1.8 billion and an adjusted TER of 1.07%.

NFJ Dividend Interest & Premium Strat (NFJ) has a market capitalization of USD 1.5 billion and an adjusted TER of 0.98%.

Cohen & Steers Infrastructure (UTF) has a market capitalization of USD 1.4 billion and an adjusted TER of 1.92%.

In comparison, consider the two ETFs we reviewed in a prior post.

Standard & Poor’s Depositary Receipts (SPDR) S&P 500 ETF (SPY) has market capitalization of USD 80.6 billion and a TER of 0.09%.

iShares S&P 500 Index (IVV) has a market capitalization of USD 23.0 billion and a TER of 0.09%.

As you can see, the ETFs both have significantly lower TERs.

Note that I chose the U.S. domestic stock CEFs with the greatest market capitalization. Not those that necessarily matched the S&P 500 (i.e. U.S. Large Blend) investment style. This may have some impact on the TER analysis, but not enough to equate ETF costs with CEFs.

Note further that I use “adjusted” TER for the CEFs. This is potentially a different number than the reported TER for a CEF.

CEFs that use debt to leverage their portfolios must include interest expense as part of the reported TER. By excluding the interest expense from the adjusted TER, the ratio is more appropriate for comparisons with the TERs of open-ended mutual funds and ETFs. When analyzing data, always make certain you compare apples to apples.

ETFs Tend to Trade at their NAV

I wrote above that price is determined by investor demand 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. 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.

As we discussed previously, 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; market efficiency; expectation of management’s ability to outperform.

In the CEFs above, the following 3 year average premiums and discounts exist: DNP 23.50% premium; KYN 11.72% premium; ETY 5.89% discount; NFJ 13.82% discount; UTF 11.94% discount. You can see there is a significant difference on both sides for these CEFs.

ETFs May Be More Liquid

Not always the case, but ETFs can be more liquid than CEFs.

From Morningstar, I selected the 5 largest U.S. domestic stock CEFs. They range in size from USD 1.4 to 1.9 billion.

Decent size funds, but a far cry from ETFs tracking the S&P 500. The SPDR ETF has a market capitalization of USD 80.6 billion and the iShares ETF a capitalization of USD 23.0 billion.

There is much less capitalization (and likely liquidity) with the CEFs.

Remember, to buy or sell a CEF 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.

The less liquidity, the greater the potential costs in your portfolio.

Conclusion

CEFs can be useful investments.

I personally like CEFs that trade at discounts to their portfolio’s NAV. My hope is that over time 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, I believe that CEF costs are 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 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.

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