Exchange Traded Fund vs Open-end fund/Closed-end fund

I’m trying to get a better understanding of exchange traded funds. Based on my understanding from reading achievable, ETF’s are open-ended funds, that can be passively or actively managed while also having expense ratio’s (side question can ETF’s have a 12b-1 fee?), but operate as a closed-end fund since the funds are traded on the secondary market. Essentially best of both worlds? They can either be redeemed by the issuer or traded on the secondary market. Having redemption feature while also trading in the secondary market allows for the ETF to trade at its NAV unlike closed-end fund which can be traded at NAV, a premium or discount.

Am I correct explaining this? If not would love to get any feedback correcting me and or sources I can use to better understand.

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Hi @aybarjx - great questions! I’ll provide answers for each part of your post:

Based on my understanding from reading achievable, ETF’s are open-ended funds, that can be passively or actively managed while also having expense ratio’s (side question can ETF’s have a 12b-1 fee?), but operate as a closed-end fund since the funds are traded on the secondary market.

Legally and technically speaking, ETFs are considered open-end management companies because of the way they are capitalized (structured). ETFs maintain an “open-ended” (varying) number of shares outstanding, even though they are traded on the secondary market. Most negotiable securities trading between investors maintain a static (fixed) number of shares outstanding, but this is not how ETFs work. To ensure an ETF tracks its target index/portfolio as accurately as possible, financial institutions (“authorized participants”) trade ETF shares with the issuer. The specifics are not important for the Series 66 exam, but you can read more about this system in this informative post from iShares (BlackRock).

You could say ETFs trade like closed-end funds, but they are not closed-end funds. They function similarly when investors trade them in the secondary market, but closed-end funds do not maintain a varying number of shares outstanding.

ETFs do not assess 12b-1 fees, which is one of a few reasons why ETFs are considered more cost-efficient than mutual funds.

Essentially best of both worlds? They can either be redeemed by the issuer or traded on the secondary market.

I wouldn’t say open-ended structures are better than closed-end structures (or vice versa), but I think I get what you’re saying. ETFs are technically open-end management companies, although they function in the secondary market like closed-end funds. If you follow the link above, you’ll learn that ETFs trade in the secondary market between investors (like closed-end funds), but also involve the issuer creating more shares or redeeming shares with authorized participants in a type of “behind-the-scenes” primary market.

Having redemption feature while also trading in the secondary market allows for the ETF to trade at its NAV unlike closed-end fund which can be traded at NAV, a premium or discount. Am I correct explaining this? If not would love to get any feedback correcting me and or sources I can use to better understand.

You got it!!! I wouldn’t expect this level of detail to be tested on the exam, but it sounds like you have a firm grasp on the mechanics of an ETF!

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Thank you for clarifying this for me. I think I now have a better understanding about ETF’s. I was under the assumption retail investors could redeem ETF shares, thank you for clarifying this. So, the commissions charged when trading ETF’s come from the BD’s since there aren’t any 12b-1 fees.

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