Open-end mutual funds may have to watch their backs now that exchange-traded funds are on the scene. But
closed-end funds aren't immune to the competition either.
If anything, the structure of the closed-end fund bears more resemblance to the exchange-traded products, or ETFs, that are being spawned by the indexing troika of
Closed-end funds and their ETF cousins are similar in that they are usually traded on an exchange. Unlike traditional open-end mutual funds, they issue a finite number of shares, and the share prices fluctuate constantly, depending on demand.
ETFs have several advantages over open-end funds. Their holding costs are often lower (0.09% annually for Barclays' new
ETF vs. 0.18% for Vanguard's
Index 500 fund, for example). And because ETF shares can be redeemed for shares of their underlying stocks, they're more tax-friendly.
But ETFs have an even bigger competitive edge over closed-end funds: They don't trade at a discount to their net asset value. These discounts have been a vexing situation for the closed-end fund world and have ignited plenty of shareholder lawsuits.
Because closed-end funds issue a fixed number of shares, the price per share depends on investor demand for those shares rather than the value of the securities held. To redeem shares, an investor has to find another buyer, so the price reflects the shares' reception in the market.
It's not uncommon for closed-end funds to trade at a discount soon after being issued. They are aimed primarily at retail buyers and are of little interest to institutional investors. For example,
, which invests in companies involved in leveraged buyouts, trades at a discount of nearly 40% to the value of its holdings. The
Templeton Vietnam & Southeast Asia
, managed by international investing guru
, is trading at a 32.8% discount.
The discount problem has gotten worse lately because investors are even less interested than usual. Despite the market decline, investors prefer to stake their fortunes in the stock market, and most closed-end funds are invested in bonds. Plus, interest rate fears continue to put pressure on bonds, eroding the net asset values of the funds and driving the discounts up. Add a slew of shareholder revolts, and investors are staying away.
"Closed-end funds are trading at a wider discount than I've seen in more than 20 years," says Phillip Goldstein, a money manager with
in Pleasantville, N.Y., who builds portfolios of closed-end funds.
Exchange-traded funds are much less likely to trade at a discount because they can hand over securities instead of selling out of positions when investors want to cash out. If there is a difference between the value of the fund's shares and the underlying securities, it usually doesn't last long. Investors can arbitrage the shares and bring those values quickly into alignment.
"The ETFs don't have the discount issue," explains Jon Maier, an analyst with
. "Redeeming shares solves that problem."
Even without the added competition posed by ETFs, closed-end funds have been a dying breed in recent years. Most closed-end funds are portfolios with illiquid positions that haven't been able to gain investor interest during an era of soaring tech-heavy funds. While there are thousands of open-end funds, but there are just 517 closed-end funds trading on the U.S. exchanges. Closed-end funds have just $123 billion in assets, while more than $4.6 trillion is tucked away in open-end funds.
New closed-end offerings come to market only sporadically nowadays, and usually with an emphasis on innovative niches, such as the
fund, a venture capital offering from
Draper Fisher Jurvetson
"As far as new products are concerned, they've been dead for so long," says Goldstein. "When you have a Germany fund trading at a 24% discount, it's hard to come out with another one and have people pay par."
Closed-end funds can breathe easy for the time being because the current crop of ETFs is all index funds, and there appears to be no ETF threat to closed-end bond funds. But closed-end funds that specialize in equities of specific countries could be vulnerable.
ETFs "pose no threat to the fixed-income funds, but there could be a valid argument in buying a Europe index" instead of a country-specific closed-end fund, says Michael McGrath, a closed-end fund analyst and managing director with
For the last four years, Barclays has offered a selection of single-country ETFs, formerly known as WEBs (they've been renamed iShares). There are 18 of them, and Barclays is getting ready to introduce several more country-specific ETFs as well as regional funds. These ETFs offer the opportunity to invest in a country's securities without the risk they'll trade at a discount to assets, as closed-end country funds often do.
The competition from ETFs may be overstated, says closed-end fund analyst Mariana Bush of
. "When the WEBs came out a couple of years ago, everybody said they would be competition for the country funds," she says.
Instead, closed-end funds have floundered on their own. The turmoil that has plagued the single-country funds -- shareholder lawsuits, liquidations and conversion into open-end funds -- "would have happened if there were WEBs or there weren't WEBs," Bush says.
Closed-end funds will face even more of a threat if actively managed ETFs become reality. Chicago's
is reported to be mulling over the idea. Active management would further erode the distinguishing characteristics between the two rival fund formats.