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The bat cave that is home to closed-end mutual funds is trying to steal some of the sunlight focused on exchange-traded funds. The goal is to sell you a toadstool when you want an easy chair.
Closed-end funds, a vestigial rump of the mutual-fund world, have seized the ETF label because it has come to represent the very investor-friendly attributes closed-ends lack. ETFs are transparent, cheap and fairly valued. Closed ends are opaque, expensive and priced on a whim.
But investors are already being duped into confusing the two. In our Start Investing community, a contributor recently posted this advice: "Consider (an) ETF on China stocks like FXI from iShares of Barclays and CAF of Morgan Stanley."
These ticker symbols refer to iShares FTSE/Xinhua China 25 Index Fund (FXI, news, msgs), which is indeed an ETF, and Morgan Stanley China A Share Fund (CAF, news, msgs), which most definitely is not -- and was trading last week for 81.5 cents per $1 of assets.
Closed-end funds aren't bad, per se. They were created to satisfy demand among sophisticated stockbrokers for specialized products they could use to juice up the generic stock/bond portfolios Wall Street sells. Closed-end bond funds, for example, typically employ leverage to boost returns far beyond the norm.
But in the hands of anyone but the experts, closed-ends are explosive. A conservative Start Investing contributor wondered why his bond fund, Nicholas Applegate Convertible & Income II (NCZ, news, msgs), was imploding -- down 8.8% in the 30 days ended Aug. 8. The answer: It invests in junk bonds, which are ground zero in a credit crunch, and, like other closed-end funds, it amplifies its bets with leverage.
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So before you invest in ETFs, make sure you're getting the genuine article and not a wolf wearing its clothes.
Valuable vultures
There's no law against a closed-end fund calling itself an ETF. It is "exchange-traded" and can be bought and sold throughout the day, as an ETF can. But there the similarities end.The starkest difference between the two portfolios is their pricing. If you buy shares of Standard & Poor's SPDR Trust (SPY, news, msgs), you can be confident you are paying for a fractional interest in the 500 stocks it owns at their current price. With closed-ends, fair pricing is achieved randomly and seldom.
The difference is in the structure of the portfolios. ETFs represent shares in pools of the exact stocks the fund is supposed to own, priced every few seconds. Specialists called arbitrageurs watch them like vultures. The moment the ETF price departs from its index, up or down, they swoop in to buy the index stocks or the ETF, whichever is cheaper, and exchange one for the other.
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New ETF productsBruce Lavine, WisdomTree president and COO, discusses some new ETF offerings.
"There are 15 to 20 large firms, like Goldman (Sachs), Morgan (Stanley) and Credit Suisse, that have dedicated ETF traders, and if there's a profit to be made, they will make it," says Bruce Lavine, president of WisdomTree Investments, an ETF operator.
That keeps discounts or premiums to a minimum; over the last year the Spider's share price has remained within five-hundredths of a percent of its fair value virtually all of the time.
Among closed-end funds, on the other hand, discounts and premiums are chronic. That's because their holdings are disclosed only occasionally, and long after the information has become stale. They do not stand ready, as ETFs do, to exchange their shares for stock at a moment's notice; arbitrage is impossible.
Continued: Which price is right?
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