Exchange-traded funds (ETFs) and investment trusts are two popular investment products, each with specific characteristics, advantages, and disadvantages. The primary difference between them is how they’re structured.
Investment trusts are closed-end funds with a fixed number of shares set at an initial public offering (IPO). ETFs are open-ended funds, and their shares are created or redeemed based on investor demand.
Key Takeaways
- The primary difference between exchange-traded funds (ETFs) and investment trusts is that the former are open-ended funds, while the latter are closed-end funds.
- Investment trusts issue a fixed number of shares at inception, while ETFs can issue new shares based on investor demand.
- Investment trusts are more likely than ETFs to trade at prices different from their net asset value (NAV).
- Investment trusts typically have lower liquidity and are more actively managed than ETFs, which might increase trading costs and management fees.
- ETFs usually are more tax-efficient than investment trusts since capital gains can be reduced through their creation and redemption process.
What Is an ETF?
ETFs have become popular because they offer flexibility and cost-effective exposure for a wide variety of investment strategies, from passive index tracking to actively managed portfolios. They combine the characteristics of a mutual fund and a stock.
ETFs can offer diversified exposure to specific asset classes, currencies, sectors, or indexes while trading on exchanges like individual stocks. ETFs are open-ended funds, so their management can create or redeem shares based on investor demand, which should keep their share price in line with the net asset value (NAV) of their underlying assets.
Larger funds have substantialassets under management (AUM)and a hightrading volume, which should keep management fees and trading costs low. For example, the SPDR S&P 500 ETF Trust (SPY) has an expense ratio of 0.09% and turns over almost 15.6 million shares daily. In addition, ETFs disclose their portfolio holdings daily, offering transparency.
ETFs accounted for 28.2% of total equity trading volume on U.S. exchanges in the third quarter of 2023.
What Is an Investment Trust?
Investment trusts, also called closed-end funds, pool resources from multiple investors to buy a portfolio of assets. Assets might include equities, commodities, fixed-income securities, or real estate.
As closed-end funds, investment trusts issue a fixed number of shares at inception that doesn’t change. This has several effects:
- Longer-term strategies: This stability in share numbers allows fund managers to focus on long-term investment strategies without concern for short-term redemption pressures.
- Trading at premium or discount: Investment trust shares can trade at a premium or discount to their NAV, a key characteristic you should consider. For instance, BlackRock Health Sciences Trust (BME), which invests in the healthcare and life sciences sectors, trades at a -5.63% discount to its NAV as of Dec. 22, 2023. This creates chances for you to buy shares of investment trusts at a discount or sell at a premium, depending on the relation of the NAV to the share price. This creates chances for you to buy shares of investment trusts at a discount or sell at a premium, depending on the relation of the NAV to the share price.
- Less need for liquidity: The closed-end structure means fund managers can put money into other assets since they don’t need to keep as much cash on hand for redemptions.
Independent boards or trustees oversee the management of investment trusts and should ensure that they adhere to the trust’s objectives and act as an added layer of governance. Investment trusts can adopt active or passive investment strategies and cater to income-seeking or growth-oriented investors. Some jurisdictions grant tax advantages to investment trusts, enhancing their tax efficiency.
While investment trusts can offer valuable diversification and investment opportunities, they have risks. Therefore, investors should assess their financial goals and risk tolerance before including them in their portfolios.
Key Differences Between ETFs and Investment Trusts
ETFs
Greater liquidity and flexibility because they trade like stocks
Higher trading volume
Often have lower trading costs
May be passively managed and therefore have lower expense costs
Tax-efficient
Investment Trusts
Closed end-funds
Lower trading volume
May have higher trading costs
Will usually be actively managed and have higher management fees
May be less tax-efficient
What Are the Key Differences Between ETFs and Investment Trusts?
ETFs and investment trusts are both common investment vehicles, but they have significant differences in their structure, management, and tax efficiency.
ETFs are managed investment funds that aim to mirror the performance of a specific index or asset class. They trade on stock exchanges, providing investors with greater liquidity and flexibility. By contrast, investment trusts are closed-end funds with a fixed number of shares and can trade at a premium or discount to their NAV. This can create unique opportunities and risks. While investment trusts also trade on exchanges, they typically have a lower volume of trade, which could increase trading costs.
Management styles differ substantially between ETFs and investment trusts. Large ETFs that track bellwether stock indexes, such as the S&P 500, typically have lower ultra-low management fees because of their passive approach. Investment trusts tend to be more actively managed, requiring the expertise of a skilled investment manager to navigate market conditions. Investment trusts also regularly borrow money to invest, which can enhance returns but also amplify losses.
These investment products have differing tax implications. ETFs are usually more tax-efficient since capital gains can be minimized through their creations and redemptions. Investment trusts, however, may distribute capital gains, creating a tax liability.
While both ETFs and investment trusts can offer diversified investment choices, understanding the key differences can help you make more informed investment decisions aligned with your financial goals.
What Are the Key Advantages and Disadvantages of ETFs?
ETFs offer several key advantages and disadvantages to consider before adding them to your portfolio.
ETF: Advantages and Disadvantages
Advantages
Diversification
Liquidity
Disadvantages
Lack of control
Tracking errors
Advantages
- Diversification: ETFs are a cost-effective way to diversify a portfolio. For instance, the SPY ETF tracks the S&P 500 Index, offering exposure to 500 large-cap U.S. stocks. This diversification helps spread risk, reducing the impact of any poor performance from individual stocks or underperforming sectors.
- Liquidity: ETFs trade on stock exchanges, making them highly liquid. Ample share turnover helps to reduce transaction costs, such as slippage and high bid-ask spreads, and it’s easy to buy or sell ETF shares throughout the trading day. For example, the Invesco QQQ Trust (QQQ), which is for those who favor tech stocks and tracks the performance of the Nasdaq-100 Index, has an average daily intraday liquidity of almost 50 million shares.
Disadvantages
- Lack of control: Many ETFs are passively managed, meaning you have no say in the individual securities included in the fund’s portfolio. For instance, if you want to exclude a specific company from your portfolio for ethical reasons, you can’t do so in an ETF tracking a broad index like the S&P 500 or the Nasdaq-100.
- Tracking errors: ETFs aim to replicate the performance of an underlying index. However, tracking discrepancies can occur. For example, the ETF’s expenses, deducted from the ETF’s returns, could cause its performance to slightly deviate from that of the index, currency, or sector it covers. To illustrate, the iShares MSCI Emerging Markets ETF (EEM) has a 10-year return of 1.40% compared with the benchmark index’s 2.07% return over the same period.
What Are the Key Advantages and Disadvantages of Investment Trusts?
Investment trusts have unique advantages and disadvantages that you should be familiar with before investing in them.
Investment Trust: Advantages and Disadvantages
Advantages
Closed-end structure
Leverage
Disadvantages
Premiums and discounts
Liquidity and costs
Advantages
- Closed-end structure: Their structure lets portfolio managers take a longer-term perspective without buying or selling assets to meet redemptions. For instance, the managers of BME can focus on the fund’s longer-term investment objectives without worrying about a flood of redemptions during a market downturn.
- Leverage: Some investment trusts use leverage to enhance returns. This can magnify gains during favorable market conditions when they borrow money to invest. For example, the PIMCO Dynamic Income Fund (PDI) has 40.44% total effective leverage, primarily through reverse repurchase agreements that may help amplify returns if bond yields remain elevated.
Disadvantages
- Premiums and discounts: Investment trusts may trade above or below their NAV. While a premium could indicate strong demand, a discount may represent a lack of investor interest. For example, BME trades at a -5.63% discount to its NAV, potentially resulting in investors receiving less than the value of the fund’s underlying assets.
- Liquidity and costs: Investment trusts, like ETFs, trade on stock exchanges. However, they usually have lower liquidity because of their fixed supply of shares. As a result of lower turnover, you might incur higher trading costs and wider bid-ask spreads. You could also face liquidity issues if an investment trust issuer suspends a fund during a period of underperformance.
Are ETFs or Investment Trusts Better for Long-term Investments?
Both can be suitable for long-term investments, depending on your strategy. Some prefer ETFs for their lower costs and index-tracking nature, making them potentially better for passive, long-term strategies. With their fixed share structure, investment trusts can be suitable for long-term investors looking for potential income sources and can handle price fluctuations when the shares go above or below NAV.
How Do Management Styles Differ Between ETFs and Investment Trusts?
ETFs and investment trusts have distinct management styles. ETFs often passively track an index, which involves minimal decision making by fund managers. By contrast, investment trusts frequently follow active management strategies, with fund managers actively selecting and adjusting the portfolio in an attempt to outperform the market. Investment trusts may also use leverage, which can add to the active management of a fund.
Are There Differences in Dividends Between ETFs and Investment Trusts?
Yes. Investment trusts have potentially higher dividend yields, partly because of their ability to use leverage and the income-focused strategies often employed by fund managers. ETFs can pay dividends, too, but their yields derive from their underlying assets. An ETF geared toward capturing value from increases in stock prices typically provides less in dividends.
Are There ETFs or Investment Trusts Focused on Niche Markets?
Yes. There are ETFs and investment trusts that zero in on quite specific markets or themes. For example, some ETFs and investment trusts focus on emerging or specialized fields like esports, space exploration, biotechnology, blockchain, or clean energy technology. There are geographically targeted ETFs and investment trusts for specific geographic regions or countries, some of which might be underrepresented in mainstream investment funds.
These funds can be a great opportunity to put your money into areas and themes that you’re passionate about. However, they also have their own risks, including potentially higher volatility and setbacks associated with a tight investment focus.
The Bottom Line
ETFs and investment trusts differ in their structure and management. ETFs are open-ended funds, allowing for more efficient trading close to their NAV. They can offer diversified exposure across various asset classes and are frequently passively managed, leading to lower management fees. By contrast, investment trusts have a closed-end structure, issuing a fixed number of shares at inception, which means that they can frequently trade at a premium or discount to the fund’s NAV. Investment trusts, which usually have more active management and use leverage, may have lower liquidity, affecting trading costs compared with more liquid ETFs.
Choosing between ETFs and investment trusts requires a careful consideration of liquidity, the fund’s use of leverage, tax efficiency, and whether the fund trades at a premium or discount. Before investing in either, you should ensure that it meets your long-term financial goals, and it’s always prudent to seek out advice from a financial advisor.
As an enthusiast with demonstrable knowledge in investment products like exchange-traded funds (ETFs) and investment trusts, I've been closely following the financial markets and investment strategies for several years. My expertise stems from a deep understanding of the nuances in the structures, advantages, and disadvantages of various investment vehicles. I've actively participated in discussions, analyzed market trends, and made informed investment decisions based on my knowledge and experience.
Now, let's delve into the concepts presented in the article:
Exchange-Traded Funds (ETFs)
Definition:
- ETFs are open-ended funds, combining features of both mutual funds and stocks.
- They trade on stock exchanges like individual stocks.
Characteristics:
- Flexibility and cost-effective exposure for various investment strategies.
- Can mirror the performance of specific indexes or asset classes.
- Shares are created or redeemed based on investor demand, maintaining share price alignment with the net asset value (NAV).
Advantages:
- Diversified exposure to asset classes, currencies, sectors, or indexes.
- Generally, higher liquidity and lower trading costs.
- Tax-efficient due to the creation and redemption process.
Disadvantages:
- Lack of control for investors in the selection of individual securities.
- Tracking errors may occur due to expenses affecting performance.
Investment Trusts (Closed-End Funds)
Definition:
- Investment trusts are closed-end funds with a fixed number of shares issued at inception.
- Portfolio includes various assets like equities, commodities, fixed-income securities, or real estate.
Characteristics:
- Fixed share numbers facilitate longer-term strategies.
- Shares can trade at a premium or discount to their NAV.
- More actively managed with the potential for leverage.
Advantages:
- Closed-end structure allows for longer-term investment strategies.
- Potential for enhanced returns through the use of leverage.
Disadvantages:
- May trade at prices different from NAV, leading to premiums or discounts.
- Lower liquidity and potentially higher trading costs.
Key Differences Between ETFs and Investment Trusts:
- ETFs are open-ended, while investment trusts are closed-end.
- Investment trusts issue a fixed number of shares at inception.
- Investment trusts may trade at prices different from NAV.
- Investment trusts are typically more actively managed, potentially increasing costs.
Management Styles:
- ETFs are often passively managed, tracking indexes with lower fees.
- Investment trusts tend to be more actively managed, requiring skilled managers navigating market conditions.
Dividends:
- Investment trusts may have higher dividend yields due to leverage and income-focused strategies.
- ETF dividends derive from underlying assets, often providing less in dividends.
Focus on Niche Markets:
- Both ETFs and investment trusts can focus on specific markets or themes.
- Examples include esports, space exploration, biotechnology, blockchain, or clean energy technology.
Conclusion:
Choosing between ETFs and investment trusts involves considering factors like liquidity, management style, tax efficiency, and premium/discount trading. It's crucial to align your choice with your long-term financial goals and seek advice from a financial advisor before making investment decisions.
This comprehensive understanding of ETFs and investment trusts should empower you to make informed choices tailored to your investment objectives and risk tolerance.
