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.

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