Many people have heard of exchange-traded funds (ETF), but to fully understand it we have to cover closed-end funds (CEF) and open-end funds (OEF) which is similar to ETF. As an example for comparison, we assume for all these funds, the underlying asset of each share consists of one GOOG and one AAPL. ## Closed-end funds Closed-end funds were the first of these structures to exist. During its IPO, a CEF raises capital once and issues a **fixed number of shares** to trade on an exchange. Suppose the fund issues 1 million shares. To back these, the fund manager would purchase 1 million shares each of GOOG and AAPL. Once the IPO is over, the fund doesn't issue new shares or buy back old ones. Now the exchange has 1 million shares. Individual investors like you and me can trade them. Suppose at one time 1 share of GOOG and AAPL is $300 and $250 respectively. The net asset value (NAV) of one CEF share is $550. What can we say about the price of the CEF on the market? Surprisingly, the price of the CEF can diverge from the NAV without any invisible hand trying to close the gap. The CEF can trade at a **discount** or **premium** to its Net Asset Value (NAV). The reason behind this is the seemingly irrelevant property of CEF: the number of shares is fixed. If the fund manager can create or destroy shares as they see fit, this gap would not exist. Suppose the CEF is traded at a premium to the NAV, the fund manager can issue new shares at the premium price and use the proceeds to buy more underlying assets. This process gains profit for the fund manager, thereby reducing the price of the fund (or increasing the price of underlying assets). The fund manager would repeat this process until the gap is small enough. Same strategy is applied when CEF is traded at a discount. As much as the fund manager wants to do this, they are not allowed to and this is thanks to the United States Securities and Exchange Commission (SEC). The mission of SEC is to protect investors. If the fund manager can create or destroy shares, they would have the incentives to make the gap larger and rip the profits later. ## Open-end funds Open-end funds came after CEF. It is also known as Mutual Funds. It does not have the discount / premium problem, because the price you buy / sell is always equal to the NAV at market close. During the day, you may leave an order for 1 share of the fund. If at the market close, GOOG and AAPL is $300 and $250 respectively, then you will be charged the NAV price which is $550. The fund manager will use the $550 to buy the underlying assets and create a new share for you. Note that this process does not involve an exchange. You always deal directly with the fund company. ## Exchange-traded funds We have discussed CEF and OEF. With CEF, you can trade intraday, but the price may deviate from NAV. With OEF, the price is equal to NAV, but you can only trade on market close. Can we have the best of both worlds? Here comes ETF. Recall that CEF price can match the NAV if the fund manager is allowed to create / destroy shares. However, they are not allowed due to conflict of interest. Therefore, the solution is to outsource the creation and redemption of shares to third party Authorised Participants (AP). An ETF will have more than one AP. They will create more shares when it is trading at a premium, and redeem (which is the technical and less violent term for "destroy") shares when it is trading at a discount. The APs will compete among each other so they have the incentives to close the gap as soon as possible. ## Summary ETF gets the best of both worlds. You can trade it anytime when the market opens, on an exchange and be assured that the price will be similar to the NAV. | | CEF | OEF | ETF | | ----------------- | ------------ | ------------ | ----------------------- | | Trade time | **Intraday** | Market close | **Intraday** | | Trade venue | **Exchange** | Fund company | **Exchange** | | Price against NAV | Deviates | **Same** | **Almost same** | | Create / Redeem | N/A | Fund company | Authorised Participants |