What are the advantages of an exchange-traded fund relative to open-end and closed-end investment companies?

Question

What will be an ideal response?

Answer 1

Although it has features similar to open-end and closed-end funds, an ETF has features that make it more attractive as a pooled investment vehicle. In fact, the dramatic growth of ETFs since their first introduction in 1993 was due to what is viewed as faulty design features of open-end and closed-end funds. Thus, ETFs have the advantage of overcoming certain design flaws. To illustrate, the price of the share of an open-end fund is the day's closing price causing transactions (purchases and sales) to be performed only at closing day prices and not at intraday prices. A closed-end fund, in contrast, is traded on an exchange and transactions can be executed at intraday prices. Because they are shares of a stock, ETFs, like closed-end funds, have the advantage of being traded at intraday prices. In this respect, ETFs are like closed-end funds. However, unlike a closed-end fund wherein its market price can trade at a significant discount from the NAV, the creation and redemption process for an ETF has the advantage of overcoming the divergence between the market price and the NAV.

Two other features give ETFsan advantage and make them more attractive than open-end and closed-end funds. The first advantageis that EFTs avoid the unfavorable tax consequences arising from the redemption of shares in a pooled investment vehicle that are found for open-end funds. Redemptions may force managers of open-end funds to sell securities (if the cash position is not sufficient to fund the redemptions), thus causing a capital gain or loss for those who held their shares. (Because there are no share redemptions for closed-end funds, this issue does not apply to them). For a different reason, this issue does not arise for ETFs. Specifically, an ETF's manager has the advantageof not having to sell portfolio securities because redemptions are affected by an in-kind exchange of the ETF shares for a basket of the underlying portfolio securities—not a taxable event to the investors under the U.S. federal income tax code. ETF shareholders as a result are subject to capital gains taxes only when they sell their ETF shares at a price above the original purchase price. ETFs do distribute cash dividends and may distribute a limited amount of realized capital gains, and these distributions are taxable. Just as with open-end funds that follow an index strategy, a passively managed ETF avoids realized capital gains and its taxation due to low portfolio turnover. However, in contrast to a closed-end fund that is passively managed, the actions of ETF managers do not cause potentially large capital gains tax liabilities that accrue to those who held their positions in order to meet shareholder redemptions due to the unique way in which they are redeemed.

A final advantage of an ETF (relative to a comparable open-end or closed-end fund) is that ETFs typically have a lower expense ratio.