The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

EXCHANGE-TRADED FUNDS

Mutual funds (MFs) and closed-end funds (CEFs) are two types of managed portfolios valued relative to their net asset value (NAV) (the value of the assets in the portfolio less its liabilities). The structure of both of these investment vehicles has some practical defects.

MFs as an investment vehicle are often criticized for two major reasons. First, the shares of MFs are priced at and can be transacted (purchased and sold) only at the end of the trading day (“at the close”). That is, transactions cannot be made at intraday prices. The second criticism relates to taxes and investors’ control over taxes. Withdrawals by some fund shareholders can cause taxable realized capital gains (or losses) for the other shareholders who have maintained their positions. CEFs, in contrast to MFs, trade throughout the trading day on stock exchanges. However, there is often a significant difference between the NAVs of the underlying portfolios and the price of a share of a CEF that is bought and sold.

Exchange-traded funds (ETFs) are a third type of managed funds, which overcome the practical defects of MFs and CEFs. Because most ETFs are based on indexes of some market, they offer pure beta returns.

Basics of Exchange-Traded Funds

Would it not be ideal if there were an investment vehicle that embodied a combination of the desirable aspects of both MFs and CEFs? The resolution to this dichotomy would require portfolios which could be traded throughout the day just ...