ETF vs. Investment Trust: What’s the Difference?

Key Takeaways

The primary difference between exchange-traded funds (ETFs) and investment trusts is that the former are open-end 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 because capital gains can be reduced through the ETF creation and redemption process.

What Is an ETF?

An ETF is an investment security that's similar to a mutual fund in that it invests in a basket of securities. However, unlike mutual funds, it trades on an exchange and can be bought or sold like a stock. ETFs aim to track a particular index, sector, commodity, or other asset.

ETFs have become popular because they offer flexibility and are cost-effective. They can be used in a variety of investment strategies, from passive index tracking to actively managed portfolios.

ETFs can offer diversified exposure to specific asset classes, currencies, sectors, or indexes while trading on exchanges like individual stocks.

ETFs are open-end funds, which means that their management can create or redeem shares based on investor demand. This should keep their share price in line with the net asset value (NAV) of their underlying assets.

Larger ETFs have substantial assets under management (AUM) and a high trading 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 10.9 million shares daily. In addition, ETFs disclose their portfolio holdings daily, offering transparency.

U.S. 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:

Long-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 to consider. For instance, BlackRock Health Sciences Trust (BME), which invests in the healthcare and life sciences sectors, traded at a -5.26% discount to its NAV as of Feb. 23, 2024. So, depending on the NAV relative to the share price, this can create opportunities to buy shares of investment trusts at a discount or sell them at a premium.
Less need for liquidity: The closed-end structure means fund managers don’t need to keep large amounts of cash on hand for redemptions and can put more to work for investors in other assets.

Independent boards or trustees oversee the management of investment trusts. They are expected to 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 and investment trusts are both common investment vehicles, but they have significant differences in their structure, management, and tax efficiency.

1. 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.

2. While investment trusts also trade on exchanges, they typically have a lower volume of trade, which could increase trading costs.

3. Management styles differ substantially between ETFs and investment trusts. Large ETFs that track bellwether stock indexes, such as the S&P 500, typically have 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.

4. 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 their key differences can help you make more informed investment decisions aligned with your financial goals.

Key Differences

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

Advantages and Disadvantages of ETFs

Advantages

Diversification: ETFs offer instant diversification at low cost. For instance, the SPY ETF tracks the S&P 500 Index, offering investors exposure to 500 large-cap U.S. stocks. This diversification helps spread risk, reducing the impact of a poor performance from individual stocks or underperforming sectors.
Liquidity: ETFs trade on stock exchanges, making many of them highly liquid. Ample share turnover helps to reduce transaction costs, such as slippage and high bid-ask spreads. Plus, it’s easy to buy or sell ETF shares of popular ETFs 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, as of Dec. 31, 2023, the iShares MSCI Emerging Markets ETF (EEM) had a 10-year return of 1.96% compared with the benchmark index’s 2.66% return over the same period.

Spot bitcoin ETFs, which began trading for the first time in the United States in January 2024, can have higher management fees than traditional ETFs.

Advantages and Disadvantages of Investment Trusts

Advantages

Closed-end structure: Investment trusts' 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) had 38.35% total effective leverage as of Jan. 31, 2024, primarily due to 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, when BME traded at a -5.26% discount to its NAV on Feb. 23, 2024, this meant that, potentially, investors could receive 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 share 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 as long-term investments. Some investors 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 who 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, a buy-and-hold approach 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. Certain ETFs and investment trusts zero in on quite specific markets or themes. For example, some focus on emerging or specialized fields like esports, space exploration, biotechnology, blockchain, or clean energy technology. There are geographically targeted ETFs and investment trusts, some regions 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-end 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, be sure that it meets your long-term financial goals. It’s always prudent to seek out advice from a financial advisor.