ETFs and Closed End Funds – Know the Difference
February 21st, 2006 at 6:33am by Tom Lydon
ETF Investor, one of the leading ETF blogs, does a nice job explaining the difference between ETFs and CEFs.
"As ETFs have steadily attracted more attention and retail investor dollars over the past five years, more and more fund companies are trying to pass off closed-end funds (CEFs) as ETFs to cash in on the ETF hype. CEFs and ETFs are not the same! Some readers will find this article a little too basic, but it really bears repeating.
A closed-end fund is a regular mutual fund with shares that trade on an exchange, typically the AMEX. CEFs have been around for decades; in fact, they were the first type of mutual fund ever sold. However, there is no guarantee that the price at which the shares trade is equal to the value of the stocks the fund holds. In fact, the net asset value of a CEF — the market value of all the fund’s assets divided by the number of fund shares outstanding — frequently deviates by 5-10% from the share price at which the fund is trading.
An ETF is also a mutual fund with shares that trade on an exchange. The difference is that an ETF allows in-kind redemption by big institutional investors. This prevents the fund’s price from deviating much from its NAV. If the NAV got way above the share price of the ETF, then large investors would buy up the ETF shares on the open market (driving up their price) and exchange them for the component stocks. And vice-versa. No deviations as with CEFs.
The simplest way to tell whether a fund is a true ETF or a CEF is to look up its symbol on any of the major online funds sites. For instance, on Yahoo Finance, every ETF and CEF has a Profile page (left hand side bar) and the text will clearly say whether it’s an ETF or CEF. If you see the words “closed-end” anywhere, it’s definitely a CEF.
So why do brokers push clients into closed-end funds when ETFs are a better and cheaper alternative? Commissions. Full-service brokers at big brokerages get paid extra when clients buy the company’s proprietary mutual funds. They don’t really get anything when the clients buy ETFs. Of course, this is not an issue with fee-only financial advisers or discount brokerages."
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