Exchange-Traded Funds (ETFs)

There are two very different types of funds that are traded on the stock exchange(s).  The dominant form is the open-ended exchange-traded fund, commonly called an ETF.  The smaller cousin of the ETF is the closed-end fund commonly called the CEF.

According to a recent Forbe’s article ETFs currently contain $725 billion in assets and could top $1 trillion in the next two years.  According to this site CEF assets totaled $335 billion in 2007.

Closed-End Funds

The weakness of the CEF is that its assets are bound up in a closed financial package.  In a way a CEF is a bit like a financial black hole — the investments inside are not reachable by the rest of the financial universe outside the event horizon.  The only way that the money is accessed is indirectly through the current price of the CEF and through cash distributions.   To take the analogy further a CEF is a bit like a “white hole” in that the internal assets can slowly radiate out in the form of cash distributions.

Because there is no effective mechanism to keep CEF price in line with NAV (net asset value) they hold they frequently trade at a premium or discount to their NAV.  This yahoo finance chart shows the ever-changing relationship between price (red) and NAV (blue) for S&P 500 covered call CEF.

The price versus NAV tracking-error in CEF pricing is a big con to CEF investments.    It does also present a couple opportunities.  1) Buying CEFs at a steep discount to their NAV is sometimes possible and 2) shorting CEFs that are at a steep premium is another opportunity.  Generally, however, I don’t advice speculating or investing in CEFs, largely because of the superior alternate — the ETF, or exchange-traded fund.

Exchange-Traded Funds (ETF)

The ETF is a really great financial innovation.  ETFs excel over CEFs because they build in a financial arbitrage mechanism that minimizes price/NAV tracking error.   The underlying components (stocks, bonds, money, etc) can be be redeemed directly from the ETF issuer in large blocks of ETF shares called creation units.  Typically 50,000 shares of an ETF equals a single creation unit.  If the NAV is greater than the price of the ETF a large investor can buy a creation unit worth of shares and resell the constituent investment pieces for a profit.  This arbitrage mechanism helps to keep ETF prices in very close correlation with the underlying NAV.

The beauty of ETFs is that they incorporate many of the best attributes of stocks, closed-end funds, and mutual funds into an efficient financial package.  ETFs, like CEFs, trade like stocks.  Because they do, they can be bought and sold in virtually any brokerage account just like any other stock.  Additionally, ETFs can do essentially anything a mutual fund can do — provide diversification, passive or active management strategies, invest in foreign or domestic securities, etc.

Often a mutual fund company will offer a particular fund it two different packages– a typical mutual fund or as an ETF.  For example Vanguard offers the Vanguard Total Stock Market fund as a mutual fund under the symbol VTSMX and as an ETF under the ticker VTI.

I have just scratched the surface of the CEF and ETF investment world with this blog article.  Suffice it to say I am a proponent of ETF investing.  Understanding the disadvantages of CEFs helps illustrate the advantages of ETFs.  In fact, I believe ETFs are one the of greatest financial innovations since the index mutual fund.  One passing word of caution.  Please be carefully not to confuse ETFs with the similar-sounding ETN (exchange-traded note).  ETFs are backed by the underlying securities they contain, whereas ETNs are simply senior debt notes that are only as secure the issuer who sells them.  For this reason, I prefer the real McCoy, the EFT.

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