Millions of investors have piled into exchange-traded funds (ETFs) over the past decade. Assets in the funds have grown from $65 billion in 2000 to $488 billion today, according to the Investment Company Institute, the mutual fund trade group. There are good reasons for this growth. ETFs offer low costs and tax efficiency. But for all their virtues, they are not always the best choice. Consider their older cousins, closed-end funds. Around since the 1920s, closed-end funds don't generate nearly as much media hype as ETFs. (Closed-end funds have accumulated $324 billion in assets today, up from $138 billion in assets in 2000.) But with markets moving erratically recently, some closed-ends are trading at bargain prices. Plus, they offer leverage. At the very least, you might want allocate assets to both kinds of investments.

In many respects, ETFs and closed-end funds are very similar. Both trade on stock exchanges, and both can hold portfolios of stocks or bonds. However, ETFs track benchmarks, resembling index mutual funds, whereas closed-end funds are actively managed. What's more, ETFs trade for prices close to their net asset value; you generally pay $1 to get $1 worth of assets. But shares of closed-end funds can trade at big discounts to their net asset value (NAV), allowing investors to pay $0.90 or less on the dollar.

Which kind of fund is best for your clients? Often the decision comes down to their appetite for risk. Consider an investor who seeks a large-cap equity fund that can serve as the core of a portfolio. A sound choice is the very popular S&P 500 SPDR (SPY), an ETF that tracks the benchmark. With the core in place, the investor may decide to select riskier funds for smaller satellite holdings. But an alternative option for the core holding could be General American Investors (GAM), a closed-end fund. Like the S&P 500 index ETF, General American holds big blue chips. And the closed-end sells at a tempting discount of 9.8 percent, according to www.ETFconnect.com. During the past 10 years, the shares of General American have returned 14 percent annually, compared to 6.6 percent for the S&P ETF.

While General American is attractive, investors should be aware that closed-ends are often more volatile than ETFs. Part of the reason for the extra risk of closed-ends is that their shares can trade at discounts (and premiums) to the underlying assets. To appreciate the hazards of discounts, compare the S&P 500 SPDR to an imaginary closed-end fund that also holds the 500 stocks of the S&P benchmark. Suppose the SPDR and the closed-end shares are both trading at $100, and the index falls 10 percent. The net asset value of the stocks in the ETF portfolio will fall 10 percent, and the share price would drop about the same amount (to $90). The net asset value of the stocks in the closed-end fund would also drop 10 percent, but shares of closed-end funds could drop even more. If investors panic, and dump the closed-end fund, the shares could fall into discount territory, selling for much less than the net asset value.

ETFs rarely sell at big discounts or premiums because of how they are created. Say an institutional investor wants to put $10 million into an S&P 500 ETF. The institution would place the order with a broker who would assemble a basket of the 500 stocks. Then the broker would contact an ETF portfolio manager, such as Barclays Global Investors, and agree to swap his stocks for shares in an ETF offered by Barclays. If the shares sold for less than the value of the stocks, the broker would not make the swap. If the shares sold for a premium to the value of the underlying stocks, the broker would race to make the swap. Although ETFs often trade in small lots on exchanges, the force of the big institutional trades tends to keep prices in line with net asset values.

The market for closed-ends operates in a very different way. Buyers — including retail and institutional investors — pay cash for the closed-end shares, which trade on stock exchanges. The share prices rise and fall according to the whims of the market, of course. Consequently, the shares often trade at discounts or premiums to the underlying portfolio. These discounts can persist for long periods of time.

Leverage, A Razor's Edge

Closed-end funds also offer leverage — which can either be a benefit or a hazard, depending on the state of the market. About three-quarters of closed-end funds borrow against their assets. In a typical deal, a municipal fund borrows by selling tax-free preferred securities. The fund may pay owners of the preferred securities a yield of 3.9 percent. But by selling the preferreds, the closed-end fund has raised cash that can be invested in municipal bonds yielding 5 percent. In this way, a fund can boost its yield, and perhaps raise total returns.

General American has leverage equal to 14 percent of its portfolio. Because of that leverage, the fund should enjoy an edge during bull markets — and face a handicap when markets drop. On average, leveraged funds outperform funds that do not use leverage over the long term. To see the power of leverage on display, compare the returns of two funds: DWS Dreman High Return Equity A (KDHAX), a conventional open-ended mutual fund with no leverage, and Dreman/Claymore Dividend & Income (DCS), a closed-end fund that typically uses 25 percent leverage. Both funds have the same manager, noted value investor David Dreman. And both funds own similar stocks, including such value names as tobacco giant Altria Group, and Freddie Mac, the mortgage company. But in 2006, the closed-end fund returned 35.6 percent, compared to 17.4 percent for the open-end. Leverage explains much of the difference. “When a top manager like Dreman sees some values, he can increase returns by applying leverage,” says Gregory Neer, a closed-end fund analyst with broker Stifel Nicolaus in New York.

Neer prefers Dreman's closed-end fund now because it sells at a relatively steep discount of 11.1 percent. Additionally, the fund has 27 percent leverage. That helps the closed-end fund to yield 6.6 percent, while the Dreman open-end pays a dividend yield of 2.6 percent.

While leverage offers advantages, it also poses risks, says Jeff Margolin, closed-end fund analyst for First Trust Portfolios, a money manager. When markets decline, leverage can magnify losses. “For their core positions, most investors should use a broad ETF, or steady mutual fund where there is no leverage,” says Margolin. “You should consider adding closed-end funds as satellite positions that can enhance yields, and help diversify a portfolio.”

One way to limit the hazards of leverage is to buy closed-end funds when they are on sale. “The time to buy closed-end funds is when they have big discounts,” says Thomas Herzfeld, president of Thomas J. Herzfeld Advisors, a Miami registered investment advisor that clears trades through Wachovia. “Funds with big discounts have limited risk, and they can cushion your portfolio.”

With investors worried about troubled mortgage markets, many closed-end bond funds have sunk to big discounts recently. Municipal portfolios look particularly appealing. While there are more than 200 closed-end municipal funds, only two tax-free ETFs exist. Herzfeld recommends Western Asset Municipal Partners (MNP), a closed-end that yields 4.6 percent, the equivalent of a taxable bond yielding 6.4 percent for a high-income investor. As the markets became shakier in recent months, the discount on the municipal fund rose from 4 percent near the beginning of the year, to the current discount of more than 9 percent. Though investors seem wary, Western Asset Municipal has 70 percent of its assets invested in bonds rated AAA.

Security analyst Gregory Neer suggests that fixed-income investors consider another closed-end, Flaherty & Crumrine/Claymore Preferred Securities (FFC). The fund, which has 36 percent leverage, yields 8.2 percent, and sells at a discount of 11 percent. Preferred securities resemble bonds, and pay fixed dividends. “The preferreds offer a bit higher yield than bonds, and that advantage gets magnified with leverage,” says Neer.

Advisors seeking stability may prefer one of the 30 taxable bond ETFs. The bond ETFs are cheap, and convenient to use. Suppose a client has $500,000 in a portfolio of corporate bonds, and he suddenly has an extra $5,000 in cash. That's too little to buy an individual corporate bond. Of course, you could put the money into a conventional bond mutual fund. But the average expense ratio for an intermediate-term bond fund is 1.20 percent, according to Morningstar. A better choice might be an ETF, such as iShares iBox Investment Grade Corporate (LQD), which comes with an annual expense ratio of 0.15 percent. The fund yields 5.6 percent, and one share costs $105. “With ETFs you can fine tune a bond portfolio,” says Anthony Rochte, senior managing director of State Street Global Advisors, a big manager of ETFs. “You can quickly increase or decrease the duration of a portfolio.”

Bond ETFs can be flexible tools for advisors who build ladders out of individual bonds. Say an intermediate-term bond matures, and the advisor cannot immediately find a replacement. To avoid holding cash, the advisor can quickly buy an ETF, such as iShares Lehman Aggregate Bond Fund (AGG), which has an average maturity of 7 years. “By using the ETF, you can easily fill the spot until the advisor finds exactly the right individual bond,” says Sue Thompson, national sales manager for registered investment advisors at Barclays Global Investors, which markets the iShares funds.

Go East

ETFs and closed-end funds can also be used to adjust the allocation of stock portfolios. Say you want to allocate more assets to the fast-growing markets of Eastern Europe. Buying individual stocks is difficult, and few conventional mutual funds participate in the region. One alternative is an ETF, iShares MSCI Austria Index (EWO), says Tom Lydon, president of Global Trends Markets, a registered investment advisor in Newport Beach, Calif., that clears trades through Charles Schwab. The Austria ETF, which trades for about $37 a share, is one of the top-performing funds in the world, returning 37.4 percent annually for the past five years, according to www.ETFConnect.com. While the fund no longer sells at rock-bottom levels, Lydon still likes Austrian stocks because of the boost that they are getting from Eastern Europe. “Many of the Austrian banks and telecommunications companies have gone into neighboring Eastern European countries, and they've been achieving big sales gains,” says Lydon.

ETFs and closed-ends can be particularly useful for advisors seeking to diversify their portfolios by holding energy or commodities. Energy Select Sector SPDR (XLE), an ETF, owns stocks such as Exxon and Chevron. Such shares tend to do well when oil prices rise. Energy investors who want a strong yield should consider the-closed-end fund, BlackRock Global Energy and Resources (BGR), which yields 5.2 percent, and sells for a discount of 11.3 percent. BlackRock produces a generous yield because it holds a big stake in master limited partnerships, vehicles that own pipelines and other assets. The partnerships pay most of their income to shareholders in the form of dividends.

For even better diversification, consider tracking oil itself, which does not necessarily move up and down with stocks. An ETF that directly tracks the price of oil is Powershares DB Oil Fund (DBO). Those who seek some safety in precious metals should consider Powershares DB Goldfund (DGL), which tracks the price of gold. “In the past, anyone who wanted to hold gold had to either trade futures, or buy coins or bars,” says advisor Tom Lydon. “All those choices were cumbersome. But now you can simply buy shares in an ETF, and get direct exposure to gold or other commodities.”

Along with using the funds to hold commodities, investors can also use ETFs and closed-ends to diversify by getting exposure to foreign currencies. The currencies do not track U.S. stocks. And many economists think foreign currencies are particularly attractive now because the dollar is weak. If the dollar continues falling, foreign holdings will rise in value for U.S. investors.

Say you are worried by the dollar's slipping, and the U.S. economy is slowing. For security, you might consider buying Swiss Helvetia Fund (SWZ), a closed-end fund selling at a discount of 13.3 percent. That way you will hold a stake in such solid Swiss companies as Nestle and UBS. More importantly, the fund is exposed to the Swiss franc. So if the franc rises against the dollar, the value of your investment will climb.

Those who worry about the dollar can also pick from a variety of ETFs that invest directly in foreign currencies. By buying CurrencyShares British Pound Sterling (FXB), you essentially invest in a bank account. The current yield on the British ETF is 5.3 percent, and the return will be higher if the pound keeps rising against the dollar. “By purchasing a currency ETF, you can put your cash to work, and diversify your portfolio away from dependence on U.S. markets,” says Time Meyer, business manager of Rydex Investments, which manages ETFs.

THE BARGIN BIN

These closed-end bond funds sell at unusually big discounts.

Fund Ticker Category Discount to NAV Yield 5-Year Annual Return
BlackRock Corporate High Yield COY High-yield 10.2% 9.8% 14.3%
MFS Investment-Grade Municipal CXH Municipal 6.5 5.4 5.1
Morgan Stanley High Yield MSY High-yield 13.4 7.4 9.6
Western Assets Emerging Markets EFL Emerging Market Debt 8.7 8.3 15.8
Western Assets Municipal Partners MNP Municipal 9.1 4.6 5.4
Source: www.ETFConnect.com; Returns through 7/31/07.