Is the "chain reaction" in ETFs behind the recent explosion in closed-end fund discounts?

Out of all the traders spooked by October's market mayhem, those that deal in closed-end funds, or CEFs, may have felt their pulses quicken the most. According to Lipper, the median discount for all CEFs plummeted 42% from 4.8% at the start of the month to a six-month low of 6.8% on Oct. 21.

CEFs 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 many traders find attractive.

After bottoming out in late October, discounts have significantly narrowed as equity markets have rallied. As of Nov. 4, the average discount climbed back to 5.7%. However, the shock was still fresh enough for veteran CEF specialist Thomas Herzfeld to detail his seven reasons for the drastic widening of discounts in his latest newsletter.

"We have been giving a lot of thought as to why discounts became so stretched recently and there are a number of reasons, some apply to all groups, while others are more focused," writes Herzfeld.

While explanations one through six are fairly straightforward -- a glut of funds, a rash of new issues, the shareholder unfriendly Citigroup ( C/ Legg Mason ( LM deal, Refco's collapse, early tax-selling, rising interest rates and a slumping stock market -- item number seven deals with exchange-traded funds and is somewhat surprising. Herzfeld blames sagging closed-end fund prices on "competition from ETFs, whose growth is beginning to look like a chain reaction."

ETFs also represent a basket of stocks and trade freely on an exchange, but they typically track an index and aren't actively managed. And unlike closed-end shares, where the premiums and discounts can be steep, market specialists and institutions tend to keep ETF shares as close to the NAVs as possible.

Gut Check

Herzfeld admits that this particular opinion is based more on his "gut feeling" rather than quantitative analysis. That's understandable; it's hard, if not downright impossible, to measure the extent to which investment advisers are steering clients away from closed-end funds and into ETFs. Unlike ETFs and open-end mutual funds, where new shares can be created or redeemed depending on demand, the closed-end funds' supply remains fixed. Therefore, closed-end supply will only increase through new issues, not demand.

Those mechanics can get overlooked amid the current ETF craze, potentially leading investors to believe that ETFs are growing at the expense of CEFs. ETFs have grown from less than $1 billion in 1993 to more than $260 billion at the end of September, just under the total $269 billion for CEFs, according to the Investment Company Institute. This growth has set off a flurry of articles questioning whether ETFs will ultimately replace open-end mutual funds and CEFs entirely.

Lipper CEF specialist Don Cassidy says Herzfeld's intuition has merit in relation to a small section of the market like REITs and utilities, where active management is less a priority for investors and expense ratios for ETFs can be substantially cheaper than a comparable CEF. The average expense ratio for the 23 available real estate CEFs is 1.2%, compared with an average cost of 0.4% for the four publicly traded real estate ETFs, according to Morningstar.

However, Cassidy dismisses the broader idea of a zero-sum fund landscape.

"ETFs may be stealing CEF business in a few isolated cases like REITs and energy, but it's important to remember that only a tiny percentage of advisers ever have used CEFs to begin with, so it is not like there is a massive potential for a shift in dollars there."

No Contest

Cassidy gives Herzfeld's hunch some credence, but other CEF analysts are more dismissive of the idea that ETFs are encroaching on CEF territory. In fact, many don't see them as competitors at all.

"ETFs are primarily equity-oriented, while the average closed-end fund buyer is looking for income," says Mariana Bush, CEF analyst at Wachovia Securities.

Bush and others point out that there are only a handful of fixed income ETFs, compared with 457 bond CEFs at last count. And of the 178 equity CEFs, many use covered calls or leverage to increase yields, neither of which is available in an ETF.

Bush attributes part of the October selloff to investors unfamiliar with the CEF structure who sold when the market turned too quickly for them.

"There have been a lot of closed-end fund IPOs this year and their high yields have been catching peoples attention," says Bush. "But not all the buyers should have been in CEFs because they don't understand the risks associated with leverage."

Yield is not the only thing investors can't get from an ETF, says Greg Drake, managing director at Claymore Securities, a firm which oversees CEF assets of $12.5 billion. Drake says the typical CEF buyer is looking for active management, another property index-based ETFs can not offer.

"Every structure has its day," says Drake. "Passive investing is popular now, however, if the S&P Index maintains its trading range for much longer, then people will be looking for active management again."

To view a video take of Gregg Greenberg's mutual fund report, click here.