ETFs Are Gaining on Closed-End Funds

By the time you read this, the exchange traded-fund industry should be at, or most probably past, an historic milestone: At least by one measure, it will have surpassed the closed-end fund industry in size.

As of December, TheStreet.com Ratings tracked 646 ETFs, only 14 short of the 660 closed-end funds in its database. Given that an average of over 20 ETFs debuted each month last year, compared with just four closed-end funds, the numbers should now be just about even. (Particularly when you take into consideration time lags in adding newly introduced funds to data feeds.)

This is especially impressive when you consider that closed-end funds have been around since at least 1927, while the first ETF debuted in February of 1993

There are a number of reasons for the popularity of ETFs relative to closed-end funds, including their slender expense ratios and the tendency of their share prices to generally maintain close proximity with net asset values.

Both ETFs and closed-end funds trade on exchanges throughout the day, like stocks. But ETFs, passively track indexes, which tends to keep their costs low. By comparison, closed-end funds are actively managed and they frequently tend to invest in relatively illiquid securities, such as foreign stocks and thinly traded municipal bonds

ETFs can also create new shares when there is sufficient demand and break them up into their constituent securities when they fall out of favor. By comparison, closed-end funds issue a fixed number of shares, and it's not unusual for their share prices to move sharply out of line with the value of their holdings for extended periods of time.

The fact that passively managed ETFs have been rewarding their holders with generally steeper, but less volatile gains than actively managed closed-end funds has not been lost on investors.

That's not to mention some lucrative tax advantages inherent in ETFs -- a factor investors should find especially appealing this time of year. Each ETF share corresponds to a basket of securities. Since this portfolio rarely change, investors generally don't incur taxes until they sell. But closed-end funds are pooled investment vehicles. Investors can incur taxes whenever a manager sells the holdings at a profit.

The first ETFs were new-fangled investments replicating popular indices such as the S&P 500 and the Dow Jones Industrial Average. The industry has since exploded, with providers offering specialized vehicles that track all manner of commodities, currencies, and esoteric phenomena such as emerging sovereign debt, metabolic endocrine disorders, Sudan-free large-cap core, ophthalmology investments and Ocean Tomo patents.

Only 33 ETFs existed at the end of 1999. The number of ETFs nearly tripled during the stock market bubble year that followed. There was brief a respite during the bear market from 2000-2002, and then their number subsequently exploded during the most recent bull market.

GROWTH OF ETFs & CLOSED-END FUNDS

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Source: TheStreet.com Ratings - Data as of 12/31/2007.

Although the population of ETFs currently roughly equals the number of closed-end funds, the popularity of the newer investment vehicles is reflected in their cumulative market value of more than $540 billion--based on SEC filings. That's already 70% greater than the corresponding figure of $318 billion for closed-end funds.

Two primary reasons for the ascendency of ETFs relative to closed-end funds are strikingly driven home in an accompanying table. While the average closed-end fund's price lagged its net asset value per share at a discount of 6.67% at year's end, the average ETF stood at a paper-thin premium of 0.12% above NAV.

In every investment objective category, the average differential between price and NAV was of a significantly greater magnitude for closed-end funds than for ETFs. For example, the average emerging market closed-end fund was priced by the market 10.47% below NAV vs. a comparable discount of 0.97% for the average in the same category. Even more striking, the average discount for health/biotech closed-end funds stood at a disturbing 12.01% while the average ETF with the same investment objective was priced at a slim premium of 0.20% above NAV.