Don't Know an ETN from a CEF? We Can Help

Question: I've long invested in conventional mutual funds, but I'd like to have a clear understanding of some of the other investment types--exchange-traded funds, unit investment trusts, exchange-traded notes, closed-end funds, and so forth. Can you highlight the major differences?

Answer: For investors familiar only with stocks, bonds, and conventional mutual funds, the variety of alternative investment vehicles on the market might seem overwhelming. As you've no doubt discovered, there are many investment types that are similar in nature to mutual funds in that they hold or track baskets of securities, but each of these has its own unique characteristics. If you've ever felt lost amid the blizzard of investing acronyms facing the modern individual investor, take heart. You most certainly are not alone.

For those seeking clarity on what some of these lesser-known investment types are and how they work, here's a primer:

ETFs
Exchange-Traded Funds
ETFs are becoming increasingly popular and are very similar to conventional open-end mutual funds in that they invest assets in a portfolio of securities, often--but not always--tracking an index.Among key differences are the fact that while conventional mutual funds are priced once a day after the market closes, ETFs are repriced and traded throughout the day. There also are structural benefits regarding how an ETF operates that often lead to lower fees compared with mutual funds investing in similar portfolios, as well as some tax efficiencies. (For more on these tax efficiencies, see this slideshow.)

ETNs
Exchange-Traded Notes
It sounds similar to an ETF but is actually quite different. An ETN essentially is a promissory note from a financial institution to match the return of an index, minus fees. Like a bond, it has a maturity date, and like an ETF it can be traded throughout the day. The danger here is that an ETN is an unsecured obligation, meaning that if the financial institution issuing it can't meet its obligations, assets invested in the ETN may be lost. For that reason investing in an ETN entails a degree of credit risk along with the risk inherent in the performance of the index it tracks. (For a fuller discussion of the perils of investing in ETNs, read this column by Morningstar ETF analyst Samuel Lee.

UITs
Unit Investment Trusts
In the broadest sense, this refers to a type of investment company that holds a fixed portfolio of securities for a specified period of time. More specifically, it is also a structure used by some older ETFs that prevents them from making distributions until the end of each quarter, from holding securities not in the indexes they track, and from lending out securities. The inability to reinvest dividends daily, as newer ETFs and conventional mutual funds may do, can lead to tracking error, in which the ETF's performance diverges from its index. No new ETF has used this structure since 2002. (Morningstar ETF analyst Michael Rawson discusses the impact structural differences can have on the performance of similar ETFs in this article.)

CEFs
Closed-End Funds
The biggest difference between closed-end funds and open-ended mutual funds and ETFs is that capital does not flow into and out of a closed-end fund based on shareholders buying or redeeming shares, as happens with the other two fund types. One consequence of this fixed-capital structure is that a CEF can trade at a substantial discount or premium to the value of its underlying portfolio. It also gives CEF managers more latitude to invest in illiquid security types than open-end fund managers and affords CEFs the ability to issue debt and preferred shares. Because of the stability of the capital they hold, CEFs are allowed to leverage their assets up to a given percentage, though not all do. CEFs often are used as income-generating investments and, like ETFs, trade throughout the day. (For a fuller description of how CEFs operate, see this recent article by Mike Taggart, Morningstar's director of closed-end fund research.)

HOLDRs
Holding Company Depository Receipts
This recently discontinued investment vehicle held a highly concentrated basket of stocks that, like an ETF, traded throughout the day. HOLDRs often were industry-specific and could be traded only in 100-share blocks. Shareholders could also take direct control of stocks held in them. Merrill Lynch created 17 HOLDRs from 1999-2001 amid the tech bubble, and last year six of the largest were converted to ETFs by Van Eck, with the other 11 being liquidated. (Morningstar ETF analyst Robert Goldsborough put some HOLDRs funds under the microscope in this 2011 article.)

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