The shareholders of the $540 million (FVD ) First Trust Value Line Dividend have come up with an unusual solution to the closed-end fund's persistent tendency to trade at a discount to its net asset value: It's being reorganized into an exchange-traded fund.

Value Line Dividend ceased trading on the American Stock Exchange on Friday. The fund's assets will be transferred to, and its liabilities assigned to, the newly created First Trust Exchange Traded Fund, which starts trading Monday under the same ticker symbol as its predecessor.

Shares of the ETF, which will track an index designed with a similar focus on dividends and capital appreciation, are being distributed to the closed-end fund's shareholders on a tax-free basis.

It's not unusual for closed-end funds to trade at a discount to the value of their holdings. That's because, unlike open-end funds, which issue and redeem shares upon request at net asset value, closed-end funds issue a fixed number of shares that can only be traded on an exchange. So the price of a closed-end fund with a net asset value of $100 per share can fall to $90 a share, or a 10% discount to its NAV, if there isn't a lot of demand for the product.

This was basically the case with Value Line Dividend. Between Jan. 1 and May 31, its discount to NAV averaged more than 12%. However, the discount has since been more or less eliminated, perhaps because investors bid up the stock price in anticipation of the reorganization. The discount shrank to 9% in June and was only about 1.3% at the end of November, according to ETFConnect.

Tom Rzepski, vice president of the American Stock Exchange's ETF marketplace, points out that the problem was not the fund's performance but that investors weren't getting the actual value of the underlying securities. (The Amex will calculate the value of the index on which the new ETF is based.)

Value Line Dividend, which invests in stocks with above-average dividends that also have potential for capital appreciation, returned 36.8% for the year to date through Wednesday, compared with a 21.5% return for the S&P 500, according to Morningstar. Over the past three years, the fund returned an annualized 19.8%, compared with 8.17% for its benchmark.

Converting into an ETF isn't the only way for closed-end funds to reduce or eliminate discounts. Some funds have conducted share buybacks, while others have been converted to open-end funds. (Another First Trust closed-end fund, First Trust/Value Line & Ibbotson Equity Allocation, was recently liquidated after a proposal to convert it into an ETF failed to attract sufficient support. First Trust subsequently launched an ETF with a similar strategy.)

There are certainly benefits to going to ETF conversion route. For one thing, it preserves shareholders' ability to trade throughout the day, whereas mutual funds price just once a day, at 4 p.m. And because ETFs are based on indices, they are more transparent than open-end funds, which may disclose their holdings just once a quarter. "The big thing is we were able to accomplish something that maintains the strategy employed by FVD and the integrity of what we are trying to do," says First Trust Chief Investment Officer Robert Carey.

ETFs also tend to have much lower costs than open-end funds. The new First Trust will have an expense ratio of 0.7%, compared with 0.93% for its predecessor fund. It's also possible to list options on ETFs, and they are generally more tax-efficient than closed-end funds.

But while other closed-end funds may opt to reorganize as ETFs, it's unlikely that it will happen on a large scale, if only because the majority of closed-end funds are actively managed. So reorganizing as an ETF could require changing the investment strategy.

Closed-end funds that reorganize as ETFs also lose the ability to use leverage, or borrowed money, to juice their returns. Alex Reiss, senior closed-end fund analyst at Ryan Beck & Co., says that roughly 75% of closed-end funds are leveraged.

"I think it's going to be a fairly limited event," he says of reorganizations into ETFs. "There is a chance that you'll see one here or one there. But certainly for the purposes of investing, trying to pick which fund is likely to become an ETF and the timing of that policy change is almost impossible to get right."

Reiss adds that the reorganization works well for First Trust because the firm has an existing fleet of both closed-end funds and ETFs. "As a firm, they're in a position to do it because they have both sides of the business."

The Amex's Rzepski notes, however, that the exchange is working on listing active ETFs. Once that happens, there could be more opportunities to convert closed-end funds into ETFs.

There are also some closed-end funds that have launched, or are in the works, with features that make it easier to convert into an ETF structure. PowerShares has a patent pending on a product that it calls the Auto-Conversion Closed-End Fund, or ACCE Fund. According to PowerShares President Bruce Bond, if the fund trades at an average discount of 3% for 30 days or more, it would automatically convert into an ETF.

He says, however, that the intent of the feature is not necessarily to convert the fund but to keep the discount at or above 3%, since investors would likely bid shares higher in anticipation of a conversion once the discount reached this level.

This product isn't an ETF, Bond says, but instead it's "a closed-end fund that has a protection feature."

Several closed-end funds also have provisions that would allow a conversion into either an open-end mutual fund or an ETF. For example, the ( RYJ) Claymore/Raymond James SB-1 Equity Fund has a conversion provision that kicks in after 18 months if the fund trades at a discount of 10% or more to its NAV for 75 consecutive trading days. In that event, shareholders would be issued a proxy to decide whether to convert the fund to an open-end format. Shareholders who don't respond will be counted as though they had voted in favor of a conversion.

"The key is to create a structure that works best for shareholders and uses the opportunity to best meet the investment objective of the fund," says Jeff Keele, managing director of Claymore. "It's not saying one structure is better. But in the particular structure that you're using, you need some protection for shareholders."

More from Mutual Funds

High-Flying Mutual Funds Begin to Favor Energy but Tech Still Reigns Supreme

High-Flying Mutual Funds Begin to Favor Energy but Tech Still Reigns Supreme

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

Mutual Funds on Track for Record Year

Mutual Funds on Track for Record Year

Bitcoin Today: Prices Come Off Highs as Rally to $10,000 Pauses

Bitcoin Today: Prices Come Off Highs as Rally to $10,000 Pauses

Video: How to Select Mutual Funds in Your 401(k)

Video: How to Select Mutual Funds in Your 401(k)