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Morningstar.com's Interactive Classroom

Course 405
Closed-end Funds vs Mutual Funds and ETFs

Introduction

As we outlined in Portfolio 404: Closed-end Funds, closed-end funds are unique investment vehicles.

That said, they do share many traits with mutual funds and exchange-traded funds.

In this course, we will explicitly lay out the similarities and differences.

CEFs and Mutual Funds

CEFs do share some traits with traditional open-end mutual funds:

  • Both have an underlying portfolio of investments with a net asset value
  • Both are run by a professional management team
  • Both have expense ratios and, typically, fee schedules
  • Both may offer distributions of income and capital gains to investors

However, traditional mutual funds issue and redeem shares daily, at the end of business, at the fund's net asset value. CEFs do not issue or redeem shares daily.

Instead, CEF shares trade on an exchange intraday, like stocks. The share price for a CEF is set by the market. The share price only rarely, and by sheer coincidence, equals the CEF's net asset value.

Also unlike traditional mutual funds, CEFs may issue debt and/or preferred shares to leverage their net assets. That leverage can increase distributions (income) but also increases volatility of the net asset value.

CEFs and ETFs

CEFs also share some traits with ETFs:

  • Both have an underlying portfolio of investments with a net asset value
  • Both trade during the day on exchanges
  • CEF and ETF shares can be treated very much like a stock, in that you can set limit orders, short the shares, and buy on margin
  • The portfolios may be leveraged
  • Both have expense ratios and, typically, fee schedules
  • Both may offer distributions of income and capital gains to investors

ETFs have a redemption/creation feature, which typically ensures the share price doesn't stray significantly from the net asset value. As a result, an ETF's capital structure is not closed. CEFs do not have such a feature.

CEFs are actively managed, whereas most ETFs are designed to track an index's performance.

CEFs achieve leverage through issuance of debt and preferred shares, as well as through financial engineering. ETFs are precluded from issuing debt or preferred shares.

ETFs are structured to shield investors from capital gains better than CEFs or open-end funds are.

Quiz 405
There is only one correct answer to each question.

1 Which vehicle is priced only once a day at market close?
a. Mutual funds
b. ETFs
c. CEFs
2 The shares of which vehicle are bought and sold on an exchange?
a. CEFs
b. ETFs
c. Both CEFs and ETFs
3 Which vehicle does not continuously offer new shares?
a. Mutual funds
b. ETFs
c. CEFs
4 What trait do mutual funds, ETFs and CEFs have in common?
a. They all are actively managed
b. They all have underlying portfolios with net asset values
c. They all are traded on an exchange
5 Which vehicle can employ leverage by issuing preferred shares?
a. Mutual funds
b. ETFs
c. CEFs
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