Closed-End Funds and ETFs
While mutual funds (open-end funds) are the most common, closed-end funds and ETFs offer important alternatives that you must understand for the Series 7 exam.
Closed-End Funds
Closed-end funds differ significantly from open-end funds:
Key Characteristics
| Feature | Closed-End Fund | Open-End Fund (Mutual Fund) |
|---|---|---|
| Share issuance | Fixed (IPO only) | Continuous |
| Trading | Exchange-traded | Redeemed with fund |
| Pricing | Market price (supply/demand) | NAV |
| Premium/Discount | Can trade above or below NAV | Always at NAV |
| Leverage | Can use leverage | Limited leverage |
| Management | Actively managed | Actively managed |
Premium and Discount
Closed-end funds trade at prices determined by supply and demand:
Trading at Premium: Market price > NAV
- Demand exceeds supply
- Investors willing to pay more than underlying value
Trading at Discount: Market price < NAV
- Supply exceeds demand
- Shares trading below underlying value
Example:
- Fund NAV: $20.00
- Market price: $18.50
- Discount: ($20.00 - $18.50) ÷ $20.00 = 7.5% discount
Exchange-Traded Funds (ETFs)
ETFs combine features of both mutual funds and closed-end funds:
ETF Characteristics
| Feature | Details |
|---|---|
| Trading | Exchange-traded throughout the day |
| Pricing | Market price (typically close to NAV) |
| Management | Mostly passively managed (index tracking) |
| Fees | Generally lower than mutual funds |
| Tax efficiency | More tax efficient (fewer distributions) |
| Minimum investment | One share (no minimums) |
| Transparency | Holdings disclosed daily |
ETF vs. Mutual Fund
| Feature | ETF | Mutual Fund |
|---|---|---|
| Trading | Intraday | End of day (forward pricing) |
| Pricing | Real-time market price | Daily NAV |
| Expense ratios | Typically lower | Typically higher |
| Sales charges | Commission only | Sales loads possible |
| Tax efficiency | More efficient | Less efficient |
| Minimums | One share | Often $1,000+ |
How ETFs Maintain NAV Parity
ETFs use an arbitrage mechanism with authorized participants:
- If ETF trades at premium: APs create new shares (buy underlying, sell ETF)
- If ETF trades at discount: APs redeem shares (buy ETF, sell underlying)
- This keeps market price close to NAV
Comparing All Three
| Feature | Open-End Fund | Closed-End Fund | ETF |
|---|---|---|---|
| Shares outstanding | Variable | Fixed | Variable |
| Purchase/Sale | Fund company | Exchange | Exchange |
| Pricing | NAV | Market price | Market price |
| Premium/Discount | No | Yes | Minimal |
| Leverage | Limited | Yes | Some |
| Expense ratios | Moderate | Varies | Low |
| Minimum investment | Often $1,000+ | One share | One share |
Exam Tip: ETF Tax Efficiency ETFs are more tax efficient than mutual funds because of the creation/redemption process with authorized participants. This in-kind process doesn't trigger capital gains like mutual fund redemptions do.
5.5 Investment Company Taxation
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