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| Why
a Closed-End Fund is not Equivalent to an ETF |
Published: April 19, 2004
I often get questions from readers regarding the many
closed-end mutual funds that are readily available to trade. At first
blush, ETFs look a lot like closed-end funds. ETFs hold multiple stocks,
bonds or other assets in a convenient package that investors can buy and
sell as if they were a stock. This confusion between ETFs and closed-end
funds is exacerbated because everybody is trying to jump on the ETF
bandwagon, especially after last year's mutual fund scandals. One mutual
fund company has managed to add to this confusion by renaming their
closed-end offerings Closed-End ETFs. These funds are not ETFs, but
instead merely represent classic closed-end mutual funds.
Closed-end mutual funds and ETFs are not the same. The similarity ends
with the fact that they both look like stocks. The differences include:
-- Closed-end funds rarely trade near their net asset value (NAV),
whereas ETFs tend to trade very close to their NAV. This is because ETFs
offer an easy-to-use way for institutional investors to create or sell
the underlying portfolio of stocks. This creates and arbitrage
opportunity that tends to keep the ETFs very close to the underlying
value of their holdings. Closed-end funds do not have this capability.
In fact, unlike ETFs, where the fund's current holdings are public
knowledge, closed-end funds, like open-end mutual funds, typically do
not disclose their exact portfolio holdings on a timely basis.
-- Closed-end funds are actively managed; ETFs are
passively managed. Since most portfolio managers tend to underperform
their benchmark, there is little incentive for me to track these funds.
-- Because closed-end funds are actively managed, in my opinion there is
no reason to believe that a trader can effectively use technical
analysis to analyze these funds. Technical analysis not only depends on
liquidity in the underlying issue, but also requires a crowd. Although
there might be a crowd trading the closed-end fund, technical analysis
cannot help me forecast what an individual portfolio manager will do.
-- Most ETFs can be shorted on a downtick. By contrast, if the market is
falling, you must wait for a higher-priced trade before you'll be able
to short a closed-end fund. You don't have to wait for that in an ETF.
-- ETFs tend to be extremely tax efficient. Their portfolios are far
less subject to change, so there is less likelihood of having capital
gains taxes passed through to you via distributions. There is more of a
chance of this happening in a closed-end fund. However, closed end funds
can more easily protect against such distributions than open-ended funds
can, because there are no redemptions. In that sense, these funds can
more easily manage their tax burden than can most ETFs, as most ETFs
must match a public index, which can be subject to change (whether the
ETF manager likes it or not).
In summary, although ETFs and closed-end funds might look alike at first
blush, they are entirely different animals. Do not be fooled by
marketing materials from mutual fund companies. Any fund that
incorporates the words "closed end" in the title is not
an ETF. Although this does not necessarily make the fund a bad
investment, you might not be getting what you thought you were.
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