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.
I like to write, except when I must. I didn’t post last week because the muse was not with me. But now she is back, filling my head with questions about the line that tries to divide sound investments from downright scams. Often that line is quite clear to many of us. We can often spot an unsophisticated scam from a mile away.
Sometimes those who should know better get taken. When a wise investor get had she is only taken for a small percentage. For example, the collapse of Enron directly impacted my investments… to such a small degree it possibly lost in the round-off error. VTI for example, because it is a market-weighted index, exposed me to a little bit of Enron.
In principle, regulation exists to combat Enron-style malfeasance. And it works to a large degree. However, for individuals and corporations alike, prudence is a perhaps more important factor. It occurs to to me that it is in my own best interest to periodically remind myself of this fact.
It for this reason that I looked up the classic Ponzi scheme to check my facts:
Then there is the legally grey red/black roulette scheme. A financial adviser collects 10% return on all investment profits. He takes the investors money and bets it on black. If the roll looses he tells the client “sorry”. If the roll wins he collects his 10 percent and does the same again at a later date… and demonstrates a 90% after expense return. Now in real life the investment vehicle isn’t literally a spin at the roulette wheel, but a similarly functioning derivatives play or plays.
There is also the advising scam. Start with 1024 target email addresses. Predict, say, the outcome of an NFL football game. Email the Colts prediction to 512 addresses and Panthers to the other 512. Send the next prediction in a similar manner to the 512 folks who were send the correct answer (ignore the others to whom the wrong prediction went). After, say 5 times, you have 32 folks who have all seen your prediction come true. Hit them up for $99 to hear your next insightful pick. If half these folks bite, there’s almost $1600 of ill-gotten gains at your disposal. Until the cops come knocking. 
[Note repeat again with the 8 folks who took your advice and you advised correctly, however this time the fee is $495. Repeat again with the four remaining folks, then new fee is $995. You get the idea.]
Prudence
It is smart and generally easy for most people to avoid big scams and cons. It is sad to hear about folks losing money at Indymac bank. Deposits over $100,000 ($250,000 IRA) will likely lose most of the excess. However, may I pointedly say “Duh!” It is helpful to get your FDIC facts straight folks. Yes, banks are safe, generally. But, come on, spread it around $100K at a time ($250K IRA). That’s pretty easy… and wise to do.
Personally, I’m asking myself “What are the risks”. Some are market-risk. Some are company-risk. There are many flavors. The US stock market is pretty well regulated. It is among the best managed markets in the world. However, stock brokers, they vary. My number 1 pet peeve is excessive fees including high expense ratios and (any!) loads. Other key peeves are lack of diversification, bad annuities (not that I know much, but someday I will do more research), and setting up or failing to adjust investor expectation.
Sadly, I’ve barely broached the topic and ideas that are coming to mind. Suffice it to say that it behooves an investor to aware of and wary of scams and schemes. A good place to start is with big, classic ones like the Ponzi. There is, I believe, a continuum of such investing parasites (parasitics?) that can drag down investment return. High fees and loads are the most obvious example. These are legal, but should be avoided.
Parting words for now… loads are just that– a big load of *%$#! Best investment wishes, and to all a good night.
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