Closed-end mutual funds were first launched in the 19th century, and for nearly a century were the main way investors could mirror their holdings on say the Indian economy or municipal bonds.

Since their launch a quarter century ago, ETFs have become the primary vehicle for investors to buy a basket of stocks or bonds tracking a particular sector and walk away, letting the market do its work.

But despite the loss of that mass market niche, closed-end mutual funds remain a popular choice among investors unafraid of some added risk who believe they can turn the sector's complexity and quirkiness to their advantage.

Closed-end funds still offer some investors the tantalizing prospect of having their cake and eating it too, combining the ability to track certain sectors with a structure that allows for greater risk taking and potentially greater returns.

How they stack up

Closed-end funds and ETFs may appeal to very different investors, but they share some key similarities.

Both have a portfolio of investments with a net asset value and offer distributions of capital gains and dividends to investors. And both closed end funds and ETFs can be traded like stocks, trading through the day on exchanges.

That's a big difference from open-end mutual funds, whose price is set once a day after the close of markets.

However, there are also key differences between ETFs and closed-end funds, differences that can be a major attraction to some investors.

One of the biggest is the ability for investors in closed end funds to snap up a basket of stocks at a heavy discount.

For closed-end fund fans, discounts rule

ETFs can create and redeem shares throughout the day. While there are arbitrage opportunities for investors, this flexibility generally keeps the stock price aligned with the next asset value of the portfolio.

By contrast, closed-end funds issue shares during an IPO. The number of shares remains fixed and does not expand or contract based on market activity as it does with an ETF.

This fixed-share structure means the price of a closed-end fund trades at each day on various exchanges and the net asset value of its underlying portfolio typically float independently of each other.

And while this can sometimes result in closed-end share prices that trade at a premium, or higher than their net asset value (NAV), more frequently it results in a discount situation.

For bargain hunting investors, this creates an opportunity to buy a $1 worth of stocks and bonds say for 90 cents, or even 85 cents.

The bet is that the discount won't widen but will narrow, rewarding the investor with a nice bump.

Since most closed-end funds trade at a discount, the key is figuring out how much of a discount the fund is trading at compared to its historic discount. If the CEF is trading at a 15 percent discount but has typically run closer to a 7 percent discount, this could hold the promise of a nice gain.

"You are able to buy same/similar assets (as an ETF) at 85 cents on the dollar (the discount) -- this increases yield, can soften downside, and increase total return," said Greg Neer, a partner and portfolio manager at Relative Value Partners, a Northbrook, Ill., wealth management firm, in an email.

Active management and leverage

ETFs generally have much lower expense ratios. They average about 0.44%, with some ETF index funds having whittled that down to pennies on the dollar.

By contrast, closed-end funds can have management fees as high as 1% to 1.5%.

The reason for the big difference is two very different approaches to investing.

ETFs are designed to ride the market, mirroring different indexes. They offer a passive approach.

Closed-end mutual funds, by contrast, pay big bucks to attract the best fund managers with the goal of beating the market.

And in their quest to get the best returns possible, closed-end fund managers can employ leverage to buy more assets and boost returns. That's territory open-end mutual funds and ETFs don't tread in.

Sixty-four percent of closed end funds were using leverage as of the end of 2017, according to the Investment Company Institute.

Closed-end funds mainly issue preferred shares to raise capital, although they can also use tender option bonds, reverse repurchase agreements and types of derivatives as well. Preferred asset shares accounted for $27 billion, or 10%, of closed-fund assets as of the end of last year, ICI notes.

"For someone who wants to take a more aggressive stance than the typical index ETF, CE funds can (and usually do) use leverage," said Warren Ward, a certified financial planner at WWA Planning and Investments in Columbus, Ind., in an email.

"Great help in up markets -- serious hindrance in down," he adds

Built to take more risks

But it's not just the ability to use leverage that enables closed-end fund managers take on riskier investments in pursuit of higher returns.

The very structure of the closed-end fund gives managers more leeway to make bets in hopes of big gains.

The fixed number of shares means closed-end fund managers don't have to fear a big outflow if they start buying shares in a high-reward but high-risk sector. Shares can change hands in daily trading, but the overall number stays the same.

By contrast, open-end funds are designed to accommodate the ebb and flow of investor interest. If investors panic and sell, the fund has no choice but to redeem their shares, with the overall number rising -- or in this case falling -- based on market demand. ETFs are also subject to the same contraction/expansion forces that govern how open-end mutual funds operate.

"Captive assets can allow managers to own more opportunistic assets, and not worry about redemptions during volatile markets," Relative Value's Neer says.

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