ETF Investing Guide: Buying Closed-End Funds in Practice

One of the advantages of both the Core ETF Portfolio and the Low-Maintenance ETF Portfolio is their breadth. Both include US, developed and emerging market stock index funds, and as such offer the potential for diversification and reduced risk, depending on the percentage of assets you assign to each ETF.

The portfolios achieve this diversification with remarkably low cost. In almost every case, ETFs Are Cheaper Than Vanguard Index Funds. However, there's one glaring exception in both portfolios: EEM, the ETF that covers emerging market stocks. The annual expense ratio for EEM is 0.75%, higher than the equivalent Vanguard fund's expense ratio of 0.57%.

Now, to exploit the advantages of discounted closed-end funds, you can replace EEM with single-country closed-end funds trading at discount to net asset value.

What will you gain by doing this?

1. You'll get the underlying stocks at a discount.
2. You'll be able to decide your asset allocation to particular countries and regions (such as China or India), instead of being forced to accept the standard weightings of the emerging markets index.
3. Greater portfolio granularity will offer you greater opportunities for rebalancing and tax-loss selling.

The downside? You'll pay more than EEM in annual expenses, and buying more funds will increase your trading costs.

A word of caution: you may well find that the discounts to net asset value do not shrink for years. Also, you’ll likely end up paying higher annual fees on these funds than on your ETFs as they are actively managed. However,

1. if the closed-end fund pays dividends, your yield will be higher due to the discount at which you bought the shares;
2. if the fund comes back into vogue, there’s a good chance the discount to NAV will shrink, and the shares of the fund will rise irrespective of the performance of the fund itself.
3. if institutional investors try to force funds trading at deep discounts to NAV to buy back shares or liquidate the fund, the discount at which the fund trades should shrink.

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