ETFs vs. Closed-End: Read the Fine Print

Editor's Note: As part of Mutual Fund Monday, Gregg Greenberg also interviewed Richard Shaker of Shaker Financial Services, whose specialty is trading closed-end funds. to read that interview, please click here.

Just because something looks and trades like an ETF doesn't necessarily make it so.

Investors often confuse exchange-traded funds, or ETFs, and closed-end funds, or CEFs, especially when it comes to investing in a single country. Nevertheless, there are significant differences between the two, and experts recommend reading the fine print before jumping into a particular fund.

"Investors need to do the same degree of comparison shopping they would normally do when choosing between funds, which means digging into things like expense ratios, historical performance and holdings," says Lipper closed-end fund specialist Michael Porter.

Closed-end fund shares are listed on securities exchanges, are actively managed and trade intraday on the open market. They typically trade in relation to, but independent of, their underlying net asset values, or NAVs. That means that unlike open-end mutual funds, shares of closed-end funds can trade at premiums or discounts to their underlying NAVs, a feature that many investors find attractive.

"For long-term holders buying a fund at a discount, all distributions are more valuable than they would be if purchased for a full dollar on the dollar," says Richard Shaker, closed-end fund specialist at Shaker Financial. "For short-term traders, being able to buy when discounts are deeper and sell when they are less is also an advantage."

Conversely, traders can also short CEF shares they believe are trading at too great a premium. Premiums and discounts arise in closed-end funds due to swings in sentiment, shifts in perception of the fund's manager, historical performance and, of course, good old supply and demand.

For example, The Brazil Fund's(BZF Quote) average discount to net asset value has been 16% over the past five years. Substantial price appreciation, however, has cut that discount practically in half. The fund is currently trading at $39.30, just an 8.5% discount.