Recently, Bill Ackman launched two IPOs that received a fairly muted response from investors. One was Pershing Square USA Ltd. (PSUS), a closed-end fund (CEF). That makes now a good time to talk about the differences between CEFs and ETFs, writes Tony Dong, lead ETF analyst at ETF Central.
Honestly, I found the structure choice a bit surprising. From what I can tell, PSUS mostly owns highly liquid large-cap stocks. In that kind of setup, I think an ETF wrapper would probably have appealed more to today’s investor base, especially younger investors.
Still, there are valid reasons CEFs continue to exist. And a lot of that comes down to three structural differences between ETFs and CEFs. This is not really a “good versus bad” discussion.
First, both ETFs and CEFs are capable of using leverage, but the way they go about it is very different. With ETFs, leverage usually comes in two forms. One is the classic daily reset leveraged ETF structure that uses swaps and other derivatives to deliver two or three times the daily return of an index or increasingly, a single stock.
CEFs, in contrast, generally use leverage in a much more traditional sense. The fund manager literally borrows money to invest. That borrowed capital increases net asset value, or NAV, exposure for better or worse.
Second is yield. One of the biggest draws of CEFs is the massive headline yields, often well into the double digits. But this is not free money. Just like ETFs, when a CEF goes ex-distribution, its NAV generally drops by roughly the same amount as the upcoming payout, all else being equal. The distribution itself is simply transferring value from the fund to the investor.
The difference is that high yields tend to be far more common in the CEF universe than in ETFs. With ETFs, double-digit yields are usually the exception outside of niche derivative income products.
Third, the biggest structural difference is the ability to potentially buy CEF shares at a market price below the fund’s NAV. This dynamic exists because unlike ETFs, CEFs operate with a fixed pool of shares. ETFs continuously create and redeem shares in kind through authorized participants, which helps keep the market price closely aligned with NAV. CEFs do not have that mechanism.
