Are ETFs Open or Closed-End Funds?

Investment funds pool capital to purchase diversified portfolios. Managed by experts, these funds offer structured investment. Their legal and operational frameworks vary, leading to distinct classifications. This article clarifies how Exchange-Traded Funds (ETFs) fit into these structures.

Understanding Open-End Funds

Open-end funds (mutual funds) continuously offer and redeem shares directly with the fund company. Shares fluctuate daily, expanding with new investments and contracting with redemptions, ensuring investors can always buy or sell directly from the fund.

Open-end fund shares are priced once daily, after trading closes, at their Net Asset Value (NAV). NAV is calculated by subtracting liabilities from total assets and dividing by outstanding shares. For example, a fund with $100M assets, $5M liabilities, and 10M shares has a NAV of $9.50. Investors don’t know their exact price until after placing an order.

Open-end funds do not trade on a stock exchange. Transactions occur directly with the fund provider or through a broker, ensuring liquidity as the fund must redeem shares at the prevailing NAV. Orders are processed based on the end-of-day NAV.

Understanding Closed-End Funds

Closed-end funds issue a fixed number of shares, typically through an initial public offering (IPO). After the IPO, the fund neither creates new shares nor redeems existing ones directly from investors.

After the IPO, these fixed shares trade on stock exchanges, similar to individual stocks. Investors buy and sell shares from other investors in the open market, not from the fund. Market price is determined by supply and demand, not solely by underlying asset value.

Due to market dynamics, a closed-end fund’s share price can trade at a premium or discount to its Net Asset Value (NAV). A premium means the market price is higher than NAV; a discount means it’s lower. For example, a $10 NAV fund might trade at $9 (10% discount) or $11 (10% premium). Investors must sell shares on the exchange to exit, as the fund doesn’t redeem them.

Understanding Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) hold diversified asset portfolios, often tracking an index. Similar to closed-end funds, ETF shares trade on stock exchanges throughout the day at market prices. This intra-day trading offers investors flexibility to react to real-time market movements.

An ETF’s market price fluctuates with supply and demand, like a stock. A unique “creation and redemption” mechanism helps align its market price with its Net Asset Value (NAV). This process involves large institutional investors, Authorized Participants (APs), who act as intermediaries between the ETF provider and the secondary market.

APs create new ETF shares by depositing a basket of underlying securities for a large block of shares. Conversely, APs redeem shares by returning a creation unit for a corresponding basket of securities. This enables arbitrage, profiting from deviations between the ETF’s market price and NAV. If an ETF trades at a premium, APs create and sell new shares, pushing the price towards NAV; if at a discount, APs buy and redeem shares for underlying securities, selling them to pull the price back to NAV.

How ETFs Bridge Fund Structures

ETFs bridge the operational structures of open-end and closed-end funds, maintaining a distinct identity. Like closed-end funds, ETF shares trade on stock exchanges throughout the day, allowing investors to buy and sell at prevailing market prices. This offers intra-day liquidity and price discovery, unlike traditional open-end funds, and enables various order types, similar to individual stocks.

Despite being exchange-traded, ETFs are “open-ended” due to their unique creation and redemption mechanism. Unlike closed-end funds, ETFs continuously create or redeem shares to meet investor demand, facilitated by Authorized Participants. This influences total shares outstanding, allowing the fund’s size to expand or contract based on market activity, like an open-end mutual fund.

The creation and redemption process prevents ETFs from trading at significant premiums or discounts to their Net Asset Value (NAV), common with closed-end funds. When an ETF’s market price deviates from its NAV, Authorized Participants engage in arbitrage, creating or redeeming shares to realign the price. This constant arbitrage keeps an ETF’s market price closely tied to its underlying assets, providing price integrity similar to open-end funds, which always trade at NAV. ETFs combine the exchange trading flexibility of closed-end funds with the NAV alignment and liquidity of open-end funds.

References

https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-etfs/mutual-funds-0
https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-etfs/closed-end-funds
https://www.investopedia.com/articles/investing/091214/understanding-closed-end-funds.asp
https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-etfs/etfs
https://www.investopedia.com/terms/e/etfcreationredemption.asp