Closed-end funds (“CEFs”) are different animals from exchange-traded funds (“ETFs”) and traditional mutual funds. CEFs do trade on an exchange, like stocks and ETFs, which leads to some confusion. However, they cannot create and redeem shares in response to changes in demand, and therefore are not ETFs. Investing in CEFs can be potentially lucrative, but investors need to be keenly aware of the price premiums and discounts, which are sometimes extreme, that typically accompany these investment vehicles. ETFs-of-CEFs provide an alternative approach for investors. Similar to fund-of-funds ETFs, these ETFs provide a portfolio of closed-end funds, greatly simplifying the process for investors.

Before jumping into the details on ETFs-of-CEFs, it is probably helpful to understand the world of closed-end funds. The key feature that makes an ETF an ETF is its ability to create and redeem shares. This, along with the continuous publishing of its intraday net asset value constitutes the soul of an ETF. These features provide the tools that allow professional arbitrageurs to keep an ETF’s trading price closely aligned to its net asset value throughout the day. If the creation/redemption mechanism is not functioning properly, then it becomes a “broken product” where premiums and discounts can develop. Traditional mutual funds only “trade” once per day at the closing, but all purchases are netted against all sales to determine how many shares need to be created or redeemed, so they also have a creation and redemption process.

However, closed-end funds generally do not create or redeem shares, except under special circumstances. The quantity of shares remains fixed, or “closed,” and trade independently of the underlying net asset value. Without the ability to create or redeem shares, there is no way to prevent price premiums and discounts from developing. This is the primary complaint about CEFs, and the reason why ETFs have greatly surpassed them in popularity.

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Disclosure: Author is long YieldShares High Income (YYY). No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF ...

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