There are a number of securities that are traded in the financial market every day, and with the passage of time, new financial instruments are being introduced in the market to facilitate investors and to offer diversification in the investment portfolio. Exchange traded funds (ETF) are one of the examples of these instruments. ETFs are investment funds that are traded on stock exchanges, and these funds track indices, bonds, commodities, stocks, or index funds. They are not like mutual funds, because they are traded on a stock exchange like a common stock. The price of exchange traded funds keeps changing during the course of a trading day as they are purchased and sold in the market.

Closed End Funds (CEFs) work the same way as ETFs. In fact, investors usually think that CEFs and ETFs are the same, even though both the instruments are different from each other. CEFs are actively managed in the market, whereas, exchange traded funds track the indexes.

The following are some of the differences between Closed End Funds and Exchange Traded Funds:

Fees of CEFs and ETFs

The expenses of the CEFs are higher as compared to the expenses of ETFs, because ETFs are indexed portfolios, and the cost of managing these portfolios is less than actively managed portfolios. Besides, the internal trading cost of actively managed portfolios is higher than the internal trading cost of ETFs, because they have a low portfolio turnover. All in all, investors can save a lot if they invest in ETFs as compared to CEFs, especially if they are seeking long-term investments.

Transparency

Exchange traded funds have outstanding transparency because they are fixed against the index. It is not hard for investors to find out the underlying financial asset of a fund, as they can simply consult the fund sponsors or index provider. On the other hand, Closed Ended Funds are less transparent, as they are actively managed.

Net Asset Value

ETFs are usually traded in the market at or near their net asset value (NAV), because it is very rare for these instruments to be traded at a large discount or premium. In the past, it was taken as an arbitrage opportunity by the financial institutions as they created or liquidated creation units, and that kept the price of ETFs closely fixed to the net asset value of a basket of securities or indexes.

Whereas, CEFs are mostly traded at a premium or discount to their net asset value. The trading at premium is usually done as a result of an increase in demand when there are more buyers in the market for CEF shares than sellers, and trading at the discount usually happens when the demand decreases. The net asset value is computed by deducting the liabilities from total assets of the fund and then dividing it by the number of outstanding shares.

Leverage

Most of the CEFs are leveraged, which increases their NAV fluctuations. If portfolio managers make the right decisions at the right time, leverage is favorable; but if they fail to make correct judgments, leverage can be very damaging for the portfolio. In case of exchange traded funds, leverage isn’t incorporated in their investment strategy; but this may change in the future.

Tax Distributions

Since ETFs are known for having low turnover, it is beneficial for investors because it decreases the likelihood of tax-gain distributions. On the other hand, actively managed portfolios have high turnover, and so there is a higher probability of frequent tax distribution.

Although both the instruments are used to help investors diversify their portfolios, the decision to choose the right instrument depends on a number of factors. However, there is always a need for due diligence to help investors make a better decision whenever they wish to add a new instrument to their portfolio.

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