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Tell apart exchange-traded funds (ETFs), closed-end mutual funds and open-end mutual funds.

FRM® Part I · Financial Markets and Products · Fund Management · FRM1.FM.3.a

The idea

Three pooled vehicles differ in how investors get in and out, and that decides how price relates to net asset value (NAV). An open-end mutual fund issues and redeems shares directly with the fund at the NAV struck after the close. The share count floats with flows, and the price is NAV, adjusted for any loads, fees or fund-specific pricing mechanisms. A closed-end fund raises a fixed amount at launch and its shares then trade on an exchange between investors. The price is set by supply and demand and can sit at a premium or discount to NAV. The fund does not redeem. An ETF trades on an exchange all day, but authorised participants create and redeem large blocks, usually in kind against the underlying basket. This arbitrage keeps price close to NAV. The usual mistake is treating an ETF like a closed-end fund. The exam point is the mechanism that links price to NAV in each structure.

Formulas

Premium or discount of a fund's price to NAV

Premium = (P − NAV) ÷ NAV

P
the market price per share
NAV
net asset value per share

Applies to exchange-traded vehicles; a negative result is a discount. Divide by NAV, not by price.

A practice question

From the question bank, with the reason each wrong option is wrong.

An investor wants to sell her entire holding in an open-end mutual fund. At what price is the sale executed?

  1. The last exchange price quoted before the order was placed.Why not: Open-end shares do not trade on an exchange; this is how closed-end funds and ETFs trade.
  2. The prevailing market price, which can be at a premium or a discount to NAV.Why not: Premiums and discounts occur for closed-end funds; open-end funds redeem at NAV.
  3. The average of the previous day's NAV and the bid price of the largest buyer.Why not: No such averaging exists; redemption is with the fund at a single NAV.
  4. The NAV struck after that day's close, less any redemption fee. - correct

Open-end funds redeem directly with the fund at the next NAV struck after the close (forward pricing), after any fees and subject to any fund-specific pricing mechanisms. There is no market price and no premium or discount.

A harder one

An ETF trades at 50.40 while the NAV per share of its underlying basket is 50.00. Which action by an authorised participant would tend to close the gap?

  1. Buy the underlying basket, deliver it to the ETF sponsor for new ETF shares, and sell those shares in the market. - correct
  2. Buy ETF shares in the market and redeem them for the underlying basket.Why not: Wrong direction: this is the trade used when the ETF trades at a discount, not a premium.
  3. Buy ETF shares and hold them until the NAV rises to meet the market price.Why not: NAV is set by the underlying basket, so waiting for it to converge to a premium price is not the arbitrage.
  4. Ask the fund to redeem ETF shares in cash at the premium price.Why not: Redemption is at NAV, not at the market price, and normally in kind.

At a premium the participant creates new shares by delivering the cheaper basket and sells the dearer ETF shares, adding supply and pushing price toward NAV.

The hardest tier

An ETF trades at 50.40 against a NAV of 50.00 per share. A creation unit is 50,000 shares, and the participant's cost of assembling and delivering the basket plus the creation fee total USD 9,500 per unit. What is the arbitrage profit per creation unit, closest to?

  1. USD 20,000Why not: Ignores the USD 9,500 of costs and reports only the gross price gap.
  2. USD 29,500Why not: Adds the costs to the gross spread instead of subtracting them.
  3. USD -10,500Why not: Takes the opposite side (buy ETF, redeem for the basket) and treats the costs as a credit.
  4. USD 10,500 - correct

Gross gain = (50.40 - 50.00) x 50,000 = USD 20,000. Subtract USD 9,500 of costs to get USD 10,500. If the gap were below the cost, the arbitrage would not occur, so the premium is bounded by costs.

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