Funds and ETFs Demystified

Elaine Phipps

Closed-end funds (CEFs), Open-end funds, Exchange-traded funds (ETFs) - what are the differences?  To help facilitate informed investment decisions, here are the basics:

Definitions and Differences

Open-end Funds – Shares in these funds are bought and sold at the end of each trading day based on the value of the fund’s net asset value or NAV.  The NAV is determined by taking the market value of the fund and dividing by the number of shares outstanding which changes each day as old investors exit and new investors enter.  There is no secondary market for open-end fund shares as purchases and redemptions are made directly to the fund manager 

Closed-end Funds – This type of fund has a fixed number of shares that are traded on an exchange, between investors.  As such, NAV is only part of the pricing determinant as supply and demand come into play.  It is common to see closed-end funds trading at a large premium or discount to NAV based on market demand.  Closed-end funds tend to be more actively managed, and often employ leverage to generate higher yields.  

Exchange Traded Funds – This type of instrument also trades on a live exchange, but the price tends to track more closely with the NAV than with closed-end funds given it is usually structured to replicate an index.  ETFs allow an investor to sell short, buy on margin, purchase very small amounts and provide settlement in three business days. 

Management Styles & Strategies

Mutual funds employ many management styles, the most common being indexed, actively-managed, lifecycle/target dated, balanced and tax-managed.   Index funds are developed to track an underlying index such as the S&P 500 and are very low cost.  Actively managed funds utilize a portfolio manager’s research and expertise, resulting in higher fees and frequently more portfolio turnover.  Lifecycle/Target date funds employ a mix of stocks and bonds, and are used when an investor is trying to become more conservative over time approaching events such as retirement or college tuition payments.  Balanced funds offer a set equity/fixed income allocation, typically in the 60%/40% range.  Finally, tax-managed funds are designed to limit turnover and thus distributions in order to keep the tax man at bay. 


ETFs and open-ended mutual funds have some of the lowest cost structures out there given the “indexed” and passive nature of their management.  The actively traded fee premium is tied to a manager analyzing and trading securities to maximize returns. Commissions and loads should also be taken into consideration, especially if an investor is purchasing small amounts on a regular basis.  With many no-load, open-end mutual funds, there are no fees on purchases, which is appealing to dollar-cost averaging investors.  Closed-end and ETFs often charge a brokerage commission for each purchase or sale, independent of the amount of the investment. 


Closed-end funds are often traded at a substantial discount to NAV, possibly greater than 10%.  This appeals to certain investors who feel they can profit in several ways.  Not only do closed-end funds generate an attractive yield, but they can also offer upside profit potential should the discount to NAV disappear as the fund’s price appreciates.    However, this strategy should be used selectively and an investor needs to do his homework before purchasing.  


 Some closed end-funds have enjoyed a recent rally due to their high dividend yields.  Many closed-end funds invest in municipal and corporate debt, using leverage to boost returns of as high as 15%.  Although this is attractive, especially now as investors search for yield and dividends, these high yields often reflect higher risk.  

How to Choose 

Prioritize what you want in terms of diversification, yield, liquidity and safety.  As with any investment, watch expenses, do research on performance, manager and trading history.  Although we still believe owning individual stocks gives an investor the ability to create his own mutual fund portfolio with more control and lower costs, the use of funds is appropriate in specific instances.  

The opinions expressed herein are the writer's alone, and do not reflect the opinions of or anyone who works for is not responsible for the accuracy of any of the information supplied by the writer.

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