As the popularity of ETFs continues to grow, it’s important to understand the four different ETF structures.
The first structure is that of a Unit Investment Trust, commonly referred to as UIT. An UIT is one of three basic types of investment companies. The other two types are mutual funds and closed-end funds.
Here are some of the traditional and distinguishing features of ITUs:
An UIT generally issues redeemable securities (or “units”), like a mutual fund, which means that the UIT will redeem an investor’s “units”, at the request of the investor, at their net asset value approximate (or net asset value) . Some ETFs are structured like UITs. Under SEC exemption orders, ETF shares are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.
An ITU will typically make a one-time “public offering” of a specific, fixed number of units (like closed-end funds). However, many UIT sponsors will maintain a secondary market, which allows owners of UIT units to resell them to sponsors and allows other investors to purchase UIT units from sponsors.
An ITU will have a termination date (a date on which the ITU will end and dissolve) which is established when the ITU is created (although some may end more than 50 years after their creation). In the case of an ITU investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When an UIT ends, all remaining securities in the investment portfolio are sold and the proceeds are paid out to investors.
An ITU does not actively trade its investment portfolio. That is, an UIT buys a relatively fixed portfolio of securities (eg, five, 10, or 20 specific stocks or bonds) and holds them with little or no change over the life of the UIT. Since an UIT’s investment portfolio is usually fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio of securities held by ITU in its prospectus.
An UIT does not have a board of directors, corporate officers or investment adviser to give advice during the life of the trust and is primarily regulated by the Investment Companies Act 1940 and Rules adopted under this Act, in particular Section 4 and Article 26.
The second form of ETF is that of the grantor trust. These ETF structures are typically used to track and hold commodities, such as gold or silver, and currencies. A unique feature of these trusts is that the original composition of the underlying basket of securities remains fixed, so it does not rebalance. If a grantor trust owns stocks, as opposed to commodities or currencies, the stock basket may become more concentrated as companies merge or are acquired.
Grantor trusts allow investors to have a direct interest in the underlying basket of securities, they distribute dividends directly to shareholders, and they allow investors to have voting rights associated with the securities held by the fund. With respect to redemptions, these structures are unique in that an individual investor can request share certificates, in round lots of 100, for each company in the trust.
Unlike many other ETFs, grantor trusts are SEC-registered investment companies and are governed by the Securities Act of 1933. The best-known family of grantor trusts is the HOLDR family of exchange-traded products.
Regulated investment company (RIC) and investment funds
A regulated investment company is the third structure. RICs are governed by the Investment Act 1940 and are common to ETFs. They are registered with the SEC, use derivatives and portfolio optimization to minimize tracking errors, and automatically reinvest dividends that are paid to shareholders on a quarterly basis.
The fund manager of an RIC has the flexibility to modify the holdings of the fund to meet the investment objectives. Additionally, the use of securities that are not included in the corresponding index being tracked is permitted to construct the fund.
RICs can be filed as undiversified funds, allowing fund managers to invest up to 50% of the fund in a single concentrated position.
The last type of structure is the investment trust. These types of ETFs are organized under the Securities Act of 1933 and can hold stocks, bonds, hard assets or derivatives. Most of these trusts are commodity related and include the SPDR Gold Trust (NYSEARCA:GLD) and iShares GSCI Commodity-Indexed Trust (NYSEARCA: GSG).
Disclosure: No position