Before exchange-traded funds (ETFs) became widely accepted, the closed end fund, or CEF, offered investors the ability to trade a diversified investment throughout the day. CEFs have a fixed number of shares such that supply and demand determines share price. Yet those prices frequently trade at a significant discount or premium to the actual underlying holdings (a.k.a. net asset value). In contrast, ETFs do not have a fixed number of shares. Discounts and premiums are typically insignificant such that market prices tend to reflect the actual underlying net asset value.
The fact that both structures are tradeable throughout a session is an attractive feature for those who, like myself, value liquidity. On the other hand, I also appreciate low costs, tax-efficiency and transparency. Most ETFs track passive indexes (e.g., S&P 500, MSCI EAFE, Barclays Aggregate Bond, etc.), carving out the expenses and tax consequences associated with active fund investment participation. What’s more, an investor usually knows what a traditional ETF is holding because an index outlines its component parts. In contrast, it may be difficult to know precisely what a CEF owns at a given point in time and CEF expenses regularly exceed 1%.
Of investment, CEF enthusiasts can point to a variety of investment that many commentators disregard altogether. For example, yield-oriented investors of CEFs often look forward to high-yielding monthly distributions that blow away the competition. How do CEFs do it? They may use leverage to enhance potential returns. Granted, the leverage can increase price volatility when a particular market is backtracking. Nevertheless, there are those who believe that the super-sized monthly distributions offset short-term price movement; many simply anticipate that price stability and/or appreciation will occur over the long period.
In sum, the primary advantage of CEF investing is its yield enhancement in a world where yield is difficult to come by. The higher yields may serve as an offset to onerous expenses as well as shorter-term price volatility. Still, how can you diversify the risk associated with the possibility of selecting an exceptionally poor CEF? Perhaps ironically, one answer has been the “fund of fund†approach where an ETF owns 30 or more CEFs.
