Blog How is an ETF Similar to a Closed-End Fund?

How is an ETF Similar to a Closed-End Fund?

Two commonly confused terms in the world of investing are an exchange-traded fund (EFT) and a closed-end fund (CEF) Although you trade CEF shares on the stock exchange, much in the same way that you can with EFTs, they are not the same thing.

However, they do share many other similarities that could make you mistake one for the other.

By gaining a better understanding of each, you can decide which to invest in for your portfolio.

What Is a Closed-End Fund?

A CEF refers to pooled assets grouped in a portfolio. There is an initial public offering, during which the fixed amount of capital gets raised, and then the shares get listed for trade during the stock exchange. 

You may hear a CEF called a closed-end mutual fund or a closed-end investment.

A closed-end fund also requires a professional advisor or manager to oversee the investor’s portfolio for active selling and buying holding assets.

This aspect of CEFs is similar to an EFT in the sense that it gets traded like equity while the price varies over the trading day.

The CEF is unique because after the initial public offering, the fund’s mother company does not give out any more shares. Neither can buy back shares get redeemed.

On the contrary, more similar to an individual stock, you may sell or buy shares on a secondary market.

So, while there are a few specific elements that make a closed-end fund distinct from an ETF, the two securities have the following things in common:

They both charge a yearly expense ratio, and shareholders can make money through capital gain and dividend distribution.

Points to Remember:

  • CEFs get created when the investment company decides to raise funds via the IPO and trade the shares on the public stock exchange.
  • You can usually generate more reliable income streams or higher returns than you can with an open-end fund.
  • The prices for CEFs fluctuate based on the supply and demand and how the holding values in the portfolio change.

What is an EFT?

An exchange-traded fund is a group of stocks that get traded throughout the day during the stock exchange. The ETF will trade close to their net value asset over the day because of arbitrage. 

The stocks that comprise the ETF trade throughout the day, as the ETF does itself. Therefore, arbitrage traders will take the opportunity presented during the day to help keep the exchange-traded fund value near the underlying basket.

There aren’t any active managers with ETFs. That’s a huge reason that the yearly expense ratios are a lot lower than that of a closed-end fund. The ETF also boasts tax advantages over the CEF.

Since holdings of an ETF are usually not managed actively, ETFs will normally hold the same underlying basket of securities for a long period. When keeping the same underlying holdings, gains will be scarce in the ETFs portfolio.

A taxable event happens every time a closed-end fund sells an underlying holding. These said taxes then get passed on to the owner of the fund. ETFs don’t get cashed out often because they do not get actively traded. That lowers the overall tax liability associated with ETFs

Points to Remember:

  • An ETF share price will fluctuate all day as it gets sold and bought; this is different from mutual funds, which trade once a day when the market closes.
  • An ETF or exchange-traded fund is a collection of securities that trade on an exchange the same way a stock does.
  • ETFs have low expense ratios, and they have fewer broker commissions when compared to buying an individual stock.
  • ETFs can have many types of investments, including commodities, stocks, or bonds; some offer U.S.-only holdings, and others are international.

How is an ETF Similar to a Closed-end Fund

  • The portfolios can get leveraged
  • They’re both traded on exchanges during the day
  • They have an underlying portfolio of investments with net asset values
  • Both have fee schedules and expense ratios
  • Both can offer income distributions and capital gains to the investor.
  • ETF and CEF shares are treated very similarly to stock. You can set limit orders, short shares, and even buy on margin.

Summary of the Differences

ETFs have a creation/redemption feature, this usually ensures that the share price won’t deviate too far away from the net asset value. Consequently, all ETFs’ capital structures are not closed.

Conversely, CEFs are devoid of this feature. ETFs track an index’s performance, and CEFs get actively managed.

Final Thoughts

If you want to know how an ETF is similar to a closed-end fund, just pay close attention to the way they get traded and the ability to generate income.

Also, both of these funds offer a way to diversify your investment portfolios to both institutional and individual investors.

The best kind of fund to choose for a particular investor depends on many variables. But the number one thing that is universal is the need for an investor to be savvy and to do the proper research concerning their investments.