I’m sitting in my favorite café, drinking a fat-free latte and not minding my own business. A small group at a nearby table is seriously discussing the markets and investing. I listen naturally. One guy was bragging about an exchange-traded fund (ETF) that made him a ton of money. He continued on and on knowledge this ETF was going to be a winner. That’s when I came in…
Sorry. I couldn’t help but overhear. Can I ask questions about this ETF?
Sure. To chase!
What type of structure is it?
Ah… I don’t know what you mean?
Well, there are different ETF structures, like Open Ended Funds, UIT, Grantor Trust, Limited Partnership, Exchange-Traded Notes. Do you know what type it is?
Not really. Does it matter?
It could….for taxes….and depending on whether it is a physical or a synthetic.
I do not know. All I know is that it went up and I made money!
I understood! Sorry to have interrupted your conversation. Have a nice day! [and exit].
As I walked away, their conversation turned to sports. Yeah, I’m a jerk, but I bet the others at the table enjoyed getting off topic.
Exchange traded funds and all the products related to them have foreign terminology to many investors. People hear “ETF” and assume that every product called an ETF is the same. They are not. The structure of the product can have big implications for investors, especially if it is held in a taxable account.
There are five basic exchange-traded product (ETP) structures: open-end funds, unit investment trusts (UIT), grant trusts, limited partnerships, and exchange-traded notes.
Open-end funds: All mutual funds are registered investment companies and are primarily governed by the Investment Companies Act 1940 and the rules and registration forms adopted under that Act. Investment companies are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. More than two-thirds of ETPs are structured as open-end funds. These are true blue ETFs. Their open structure is typically used by companies whose primary objective is to provide exposure to equity and bond asset classes.
Dividends and interest received by an open-end ETF can be immediately reinvested as they enter the fund. Derivatives can also be used in the portfolio. Open-ended ETFs that meet certain Internal Revenue Service (IRS) standards are treated for tax purposes as flow-through entities, with income and capital gains distributed to shareholders and taxed at the shareholder level.
Unit Investment Trust (UIT): The second type of ETF regulated by the Investment Companies Act 1940 is one that is structured like an UIT, although it is not technically a mutual fund. Although only a few ETPs use this structure, they are among the most important. SPDR S&P 500 (ticker: SPY) SPDR S&P 400 (ticker: MDY), Powershares QQQ Trust (ticker: QQQ) and SPDR Dow Jones Industrial Average (ticker: DIA) are UITs.
An UIT is an unmanaged pool of assets that is inflexible. Securities of an UIT must exactly replicate the index they track. Unlike an open-ended fund, no board of directors or investment manager exists to make subjective decisions about the portfolio. Like open-ended funds, UITs that meet certain IRS standards are treated for tax purposes as flow-through entities whose income and capital gains are distributed to shareholders and taxed at the shareholder level.
Grantor trusts: Grantor trusts are used to invest in commodities or “physical” currencies. They do not hold derivatives. SPDR Gold Trust (ticker: GLD) which holds gold bullion and CurrencyShares Euro Trust (ticker: FXE) which holds real euros are good examples.
Since the underlying investments of the grantor trusts prevent them from being treated as mutual funds or UITs, they are not governed by the Investment Companies Act 1940. They are governed by the Securities Act of 1933 and the Securities Exchange Act of 1934. These two laws cover the issuance of individual securities and how those securities trade on stock exchanges. The grantor trusts view investors as direct shareholders of the underlying investment. Thus, investors are taxed as if they directly owned the underlying asset.
Partnership limit: These ETPs are unincorporated business entities that elect to be taxed as a partnership and receive a K1. The advantage is that they avoid double taxation both at the level of the entity and at the level of the investor. Partnership ETPs are generally regulated as commodity pools by the CFTC.
Like open-end funds, limited partnerships can host many different types of investments, including futures and swaps. This is useful for creating “synthetic” exposure to a market, which provides investors with indirect access to commodities that are difficult to physically store. For example, partnership ETPs that track natural gas and oil using futures contracts such as The United States Oil Fund (ticker: USO).
Exchange Traded Notes (ETNs): ETNs are debt securities that have a contractual obligation to pay a specified return at maturity. In most cases, this amount is equal to the performance of a particular index or market, less expenses. ETNs generally do not hold assets. Investors become unsecured creditors of the issuing entity. This creates credit risk in addition to market risk. ETNs are popular for niche markets, sectors or strategies, such as emerging markets, currencies and commodities strategies.
Like bonds, ETNs have a predefined maturity date. Unlike bonds, they generally do not pay interest. Most ETNs enjoy favorable tax treatment as prepaid futures. Any accrued interest or dividends, and any appreciation in the value of the index, are generally built into the value of the ETN. Taxes are paid when you sell ETN shares. ETNs are a promise to pay; they are not regulated by the Investment Companies Act and lack most of the investor protections provided under its framework.
The above definitions are by no means complete and should not be relied upon for tax advice. There are several exceptions to the rules. Consult your tax advisor if you have specific questions.
I’ve used the term exchange-traded product (ETP) many times rather than referring to everything as an ETF. An exchange-traded “fund” is a specific type of product structure that technically does not match all other structures. You could say that all ETFs are ETPs, but not all ETPs are ETFs. There are mixed feelings on this issue in the investment community.
Dave Nadig, chief investment officer at ETF.com, prefers to call everything an ETF. This may be a somewhat biased view given his company’s name, but Nadig makes sound points: “In our editorial world, we’ve adopted ‘ETF’ as the ‘Kleenex’ brand for the structured product encompassing the Investment Companies Act of 1940. registered mutual funds. , UIT, Grantor Trusts, Commodities Pools and Exchange Traded Notes. Nadig admits it’s not perfect, “Technically probably just law [Investment Company Act of 1940] funds must be considered [an ETF].”
Vanguard agrees with this view. In Vanguard’s investor education guide titled ETF Structures at a Glance, each product structure is referred to as an ETF. The guide does not mention exchange-traded products or use the acronym ETP.
Charles Schwab disagrees. In its Overview of Exchange Traded Product (ETP) Structures brochure, Schwab writes: “Although most investors will be familiar with the term ETF, several other investment products are also traded on an exchange and are therefore similarly classified… Because ETFs represent the vast majority of such exchange-traded investment products, the term is often used as a catch-all, however it is more accurate to use the term “exchange-traded product” (ETP) as the umbrella term. under which ETFs and other related investment products fall.”
Deborah Fuhr divides products into two mutually exclusive types, ETFs and ETPs. Fuhr is the managing partner of ETFGI, a research and advisory firm, and probably the most respected analyst in the industry. According to her, ETFs only include open-ended funds and UITs, while all other structures are ETPs. “Exchange-traded products (ETPs) are products that have similarities to ETFs in the way they trade and settle, but do not use open-end funds [Investment Company Act of 1940] structure.”
Personally, I called a whole ETP in The ETF Book, then separated the products into different categories: ETFs, UITs, LPs, Grantor trusts and ETNs. So why isn’t the title of my book The ETP Book? For the same reason, ETF.com calls everything an ETF and Fuhr’s company is called ETFGI rather than ETPGI – few people would recognize our brands otherwise. As Nadig says, “I think this battle is lost”.
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