The issuance of shares for ETFs and CEFs are distinctly different. While the CEFs’ issued fixed number of shares in the IPO is constant throughout the life of the fund, the ETFs can and issue/redeem shares through an authorized participant. The mobility to create new shares or redeem existing ones, makes ETFs shares trade very close to its NAV, in contrast to that of CEFs, which can substantially deviate from NAV driven by the supply and demand in the market.
As the ETFs are usually passive, tracking some specific index of stocks or bonds, the managers have limited ability to deviate from the predetermined style as he/she buys or sells assets only when a change takes place in the composition of the index. In contrast, CEFs are actively managed and the managers trade based on their personal judgement. This freedom allows managers to deviate from the initial strategy and pick instruments that are considered to have more potential.
ETFs have a tax advantage over CEFs, as the purchase or sale of fund’s shares doesn’t involve capital gains. For instance, if the shareholder sells its shares, the ETF just transfers them to the buyer, while the CEF has to create a capital in this case, because it have to sell the shares in order to return money back to the seller. These capital gains are then passed on to shareholders at the year-end.
ETFs are considered very transparent as the investor has full information on the constituent securities of the ETF, which are published daily. Conversely, as the CEFs are actively managed, its component securities and their weighs fluctuate over time. So the investor is only able to check the component securities when the fund releases a quarterly or semiannually report.
As the ETFs only buy or sell securities when the followed index adds or removes securities, the trading volume is tiny, which makes the expenses associated with trading significantly less in comparison to CEFs. CEFs are actively managed, therefore incur higher trading costs and thus the trading expenses for the investor is also higher.
ETFs usually have lower management fees as they are passively managed and the portfolio managers’ role is not as significant here as is in case of CEFs.
Generally, ETFs don’t use leverage. CEFs are allowed and usually do use leverage. While the leverage can boost returns for the investor, it also increases the risk. So the decision to make between these two depends also on the risk/return characteristics of the investor.
All these 6 points discussed above can help to make a choice between ETFs and CEFs, however, one must take into consideration its personal investment strategies in making decisions whether to invest in one or the other type of fund.