If you’re looking for a more cost-effective instrument, you may want to consider exchange-traded funds (ETFs), which have been described by US supporters as revolutionizing the world of investing, with their low expense ratios and ease of transaction. Another pooled-investment tool that shares cost-effective similarities with ETFs is closed-end funds (CEFs).
ETFs are baskets of stocks or bonds that trade on a stock exchange, just like shares. ETFs are unique because of their indexing feature. Just like an index unit trust fund, ETFs aim to track the performance of a benchmark.
ETFs are also unique in that they have market makers. Usually, investment banks work behind the scenes to create or redeem ETF units. So, don’t look at the average trading volume as a reflection of liquidity. Market makers are there to create or redeem units based on demand.
A lower expense ratio is most commonly cited as the ETF’s greatest advantage. Another positive feature is flexibility. Like stocks, ETFs can be bought and sold at on-the-spot prices. It’s a very transparent investment. Even if there is a premium or discount, it will be very small and will quickly narrow.
However, ETFs don’t necessarily provide better returns. As it tracks an index, ETFs will only do well when the underlying stocks or bonds perform well. When the reverse happens, the ETFs will do just as badly. Thus, investors are still subject to market risk and volatility.
What is considered as the biggest benefit can also be a drawback. As the investor incurs a trading fee each time he buys or sells units, the costs add up when more transactions are made, eventually eroding any cost benefits. Therefore, investors are not advised to trade ETFs frequently.
A CEF is essentially a fund that has a fixed number of shares and trades on the stock exchange. However, it is a company and is governed by company law. Investors are regarded as shareholders. Because they are listed on the stock exchange, like shares, the price and liquidity of CEFs are determined by market demand and supply.
CEFs have a fund management team that works towards the funds’ objectives. As CEFs are normally smaller than unit trust funds, some believe ‘active management’ of the fund is easier, thus allowing them to perform better.
As a listed entity, the buying and selling of CEF units are done between investors on the stock market. This way, the base capital of a CEF is fixed and management can focus on investing without worrying about investors leaving or coming into the fund with large sums of money.
CEF investors also enjoy the same price flexibility as ETFs as CEF units are traded at whatever price it happens to be at during the day. Unlike ETFs, CEFs can invest in foreign-listed securities with the approval of shareholders and the Securities Commission. CEFs don’t need to market or distribute their funds and cost savings on these expenses can be quite hefty.
However, as a listed security, the price of a CEF is determined by market sentiment. So, there is no assurance that CEFs will trade at their NAVs. In contrast, ETFs have fund houses and market makers respectively, to ensure that their units trade close to their NAVs. As with ETFs, CEFs are subject to market volatility and risk. Price changes may be temporary or extended and these changes can impact the CEF’s NAV.
While there are risks and benefits, the existence of these investing instruments provides investors with a choice.