Closed End Funds Vs. ETFs, Which Is Better For You?

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Includes: ADX, BME, BND, DLN, GAB, GGN, HYND, MCR, SPY, UTG, VTI, XLE, XLK, XLU
by: Reuben Gregg Brewer

Summary

CEFs have a long history behind them, but remain an obscure investment option.

ETFs are fairly new to the investing world, but have a huge following.

Which one is right for you depends on what you want from your investments.

Some of the oldest closed-end funds, or CEFs, like Adams Express (NYSE: ADX), trace their history back as far as the Great Depression. The oldest exchange traded funds, or ETFs, meanwhile, date back to only the early 1990s. But new and exciting things often get the most attention in the market, and ETFs have blossomed while CEFs continue to be the investment world's unloved step child. That said, it's worth looking at the pros and cons of the two products. You might just decide that unloved and obscure is more to your liking.

What ETFs do well
The one thing that ETFs do really well is cheap. Many ETFs have expense ratios in the 0.2% range. And their structure, which is fairly complex, is specifically designed to avoid passing capital gains on to shareholders, although that's not always possible. This said, the cheapest ETFs are generally pure index following securities, tracking broad indexes like the S&P 500, for example.

Newer ETFs are often set up to track more obscure indexes or slices of indexes. Or they have some screening overlay. Whether or not these variants cost more money to run or not is debatable, but ETF sponsors are certainly charging more. For example, the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration ETF (NASDAQ:HYND), yes that is the ETF's real name, has an expense ratio of 0.48%. Some ETFs are even more expensive. Unfortunately, many of the newer funds, like this one, really aren't meant for novice investors.

Closed-end funds, meanwhile, don't do such a good job when it comes to costs. Adams Express is one of the cheaper options, with an expense ratio of about 0.6% according to the Closed-End Fund Association. It isn't odd to see CEFs with expense ratios of around 2%. That's a notable disadvantage compared to ETFs, though higher cost funds often make use of leverage, which elevates expenses but can help augment performance during good markets. (Leverage tends to exacerbate losses in bad markets.)

ETFs also do a good job with diversification. With one relatively cheap security you can get exposure to a broad market index, a specialty index, or the list of stocks that pass some unique screening technique. While closed-end funds aren't usually structured around an index, they too provide diversification. So, too some extent, this issue is a wash and I wouldn't assign a clear winner either way.

In fact, as ETFs have proliferated, they have become increasingly more obscure-a fact that could lead investors to buy something that may not be as diversified as they think. For example, nearly a third of the Energy Select Sector SPDR ETF (NYSEARCA:XLE) is in just two stocks, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). That's a lot less diversification then you might be expecting.

What ETFs do badly
If you believe fully in the efficient market hypothesis, then buying index funds is the only thing you'll ever do. And ETFs will be a great choice. However, I've found that markets are efficient on the whole, but not at all times. Investors often send stocks to unreasonable lows and unreasonable highs. At the low end, savvy investors can pick up bargains. At the high end, capitalization weighted indexes wind up over exposed to the best performers. That can lead to steep sell offs when investing tides start to turn since ETFs can't decide to take profits and move on to another opportunity.

ETFs that use fundamental screening techniques, equal weighting, and fundamental weighting all attempt to deal with this issue. But following an index means you are stuck with whatever that index is doing, even if you Jerry rig the index it to create a good sales pitch. Wisdom Tree's entire business is built on using screening techniques and different weighting schemes, with products like the WisdomTree LargeCap Dividend ETF (NYSEARCA:DLN), which invests in large cap dividend payers and is weighted by dividend. It's a good story if you like dividends, but the yield is around 3.8%, not exactly a huge dividend story. And the portfolio is only rebalanced on an annual basis, look out if something bad happens to a top holding during the year.

Closed-end funds, with human beings at the wheel, can make choices. That may be as base as getting out of the market during a downturn (index funds can't do that) or buying a company that looks horrible based on numbers, but has some other attribute that suggests its luck is about to turn. Examples of that include things like a new contract or a change in management. And with no need to buy and sell shares every day like an open-end mutual funds, manager of closed-end funds have more freedom than the managers of most publicly available pooled investment products to do what they believe is best.

This actually leads to one of my biggest pet peeves with ETFs-they can't discriminate or choose not to. For example, an ETF that invests in the utility industry will likely own whatever utilities are large enough and liquid enough. The biggest utilities get the most money. That's it, that's the "magic" behind the ETF. It doesn't matter what the regulatory environment is in a utility's region, even though that's an incredibly important factor in a utility's future. As long as an ETF knows its a utility and can trade it, it's in. CEF, the Reaves Utility Income Fund (NYSEMKT:UTG), on the other hand, looks at regulatory environments, among other things, when assessing an investment. The human touch may raise the price of admission, but it can add value in many situations.

What CEFs do exceptionally well
One thing that CEFs do well that most other investments don't, including most ETF and open-end mutual funds, is income. Many closed-end funds are specifically designed to pay investors a set monthly or quarterly distribution. With more and more baby boomers reaching retirement age, a steady income stream is going to be increasingly important. If that's what you're looking for, you should at least consider CEFs.

There is a legitimate debate to be had about the implications of return of capital, which CEFs can use in bad years to sustain a distribution. That can lead to the fund's net asset value falling over time if return of capital is used too often. However, in a bad market, you might have to dip into capital, too, if you were managing your own portfolio. And it's important to note that return of capital is a complex issue. If the funds net asset value, or NAV, is going up, then return of capital isn't that big a concern because it's likely more of an accounting issue than anything else.

Reaves, for example, has never cut its distribution and never used return of capital. The BlackRock Health Sciences Trust (NYSE:BME) is another fund that's done well over the long term with scant use of return of capital. That said, in fiscal 2014 return of capital accounted for roughly 2% of its fiscal 2014 distributions. Since the NAV was up over $5 during that year the $0.07 a share or so of return of capital really wasn't a big deal.

Another thing that closed-end fund do well is bargains. This is because they trade like stocks, but have portfolios like ETFs or mutual funds. Thus, the NAV of a closed-end fund can differ materially from its share price (in a truly efficient market this would be impossible, by my thinking). That can allow an investor to pick up $1 worth of investments for as little as $0.80. ETFs rarely trade far from their NAVs (open-end mutual funds never do). So if you like deals, CEFs win hands down.

This or that
So what type of investor would want an ETF? The most obvious choice is someone looking for the cheapest and easiest way to gain exposure to a given market or sector. For example, an investor looking for broad stock market exposure might choose the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the granddaddy of S&P 500 ETFs, or for even more diversification, the Vanguard Total Stock Market ETF (NYSEARCA:VTI), which essentially tracks the entire U.S. stock market. SPY's expense ratio is 0.0945% and VTI's expense ratio is an even smaller 0.05%. Pair these up with a bond ETF, like the Vanguard Total Bond Market ETF (NASDAQ:BND), and you have a diversified portfolio. BND's expense ratio, by the way, is just 0.08%.

With just two ETFs, you'd get exposure to every U.S. stock and bond with minimal expense. That said, not everyone wants to use a hands free approach. For more active investors, ETFs are also good for someone looking to time the market or jump into a hot sector without having to know much about the companies in it. Want exposure to technology because you think it's about to take off? Try the Technology Select Sector SPDR ETF (NYSEARCA:XLK). It's relatively cheap and gives you a portfolio filled with some of the largest and most important tech names in the world. You can find an ETF for just about any sector you might be interest in jumping in and out of quickly.

But, as I noted above, there can be drawbacks to investing in an index. The Reaves Utility Income Fund is a great example. Not all utilities are made equal and there are factors beyond being included in the S&P 500 Index that may make a utility worthwhile, or not. So by purchasing the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) you will quickly own the utilities in the S&P 500, but not necessarily the utilities best positioned within the industry. Reaves takes a broader look at the companies and industry.

And if you are looking for income you'll definitely want to look at CEFs, which do income better than most other pooled investment products. For example, pair the Gabelli Equity Trust (NYSE:GAB) with the MFS Charter Income Trust (NYSE:MCR) and you have a broadly diversified portfolio. And since GAB pays out $0.15 a share quarterly for an around 8% yield and MCR pays $0.045 a share every month for an around 7.5% yield, you'll have a nice income stream to live off of. To some extent, these two funds were picked at random, but they get the point across. For comparison, VTI's yield is around 1.8% and BND's yield is about 2.7%. That's a lot less to live on.

In addition, if you like the idea of finding bargains driven by human inefficiencies, CEFs are the way to go. For example, GAMCO Global Gold, Natural Resources & Income Trust (NYSEMKT:GGN) has a habit of selling for less than its NAV toward the end of the year with the gap closing as the new year progresses. Just such a trading opportunity took place this past month.

But, longer term, you can find bargains, too, since many closed-end funds trade at discounts to their NAVs, often for long periods of time. That, in turn, increases the income you earn from the CEFs relative to owning the securities in the fund's portfolio directly. A fund with a 10% discount to NAV means a fund paying you 10% more than you would get if you bought the same portfolio directly. MFS Charter Income Trust, for example, is trading at an over 10% discount according to the Closed-End Fund Association.

Beauty is in the eye
In the end, both ETFs and CEFs have their pros and cons. I've only touched on the issues I think most salient, I'm sure you can find some more things to like and hate about each. That said, they both have their place in the world of investing. If you believe there are inefficiencies in the market and like the idea of a human being being involved in the investment process, you'll want to look at closed-end funds despite their negatives. If you prefer computer driven and cheap, then ETFs will be your masterpiece, even though they aren't perfect.

But, regardless of which one you pick, you should take the time to think about how their inherent strengths and weaknesses fit with your portfolio and personality. It could save you from jumping ship at exactly the wrong time or open you up to a whole new area of the investment world that you've never looked at before.

Disclosure: The author is long GGN, BME.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.