The maddening landscape of
exchange-traded funds (ETFs)
hasn't just created a plethora of indexing strategies - it's given birth to
numerous product structures.
Choosing one ETF product
structure over another will
affect important matters such as how dividends are paid, the margin of tracking
error and even taxes.
Key
Legal Structures
Generally, most traditional
bond and equity ETFs are organized as either open-end funds or unit investment
trusts (UITs). Investment products that track commodities, currencies, or
other specialized strategies are typically registered as grantor trusts,
exchange-traded notes, or partnerships. Although some of these structures share
similar characteristics to traditional ETFs, they are not necessarily registered
or taxed the same.
Here's a
brief summary of each:
Open-end index fund
The majority of ETFs follow the open-end
structure because it allows the greatest flexibility. Dividends in these types
of funds are imimmediately
reinvested and paid to shareholders on a monthly or quarterly basis. Open-end funds are
registered under the Investment Company Act of 1940. ETF families that have this
legal structure include iShares, Select Sector SPDRs, PowerShares, Vanguard, and
WisdomTree.
Unit Investment Trust (UITs)
The oldest and best known ETFs - including the
BLDRs, Dow Diamonds, SPDRs, and PowerShares QQQ Trust - are organized as UITs.
This type of
legal structure does not reinvest dividends in the fund, but instead holds
dividends until they're paid to shareholders quarterly or annually. Unlike
open-end funds, UITs have expiration dates which can range from a period of
years to decades. Most expirations are continuously rolled or extended. UITs are
registered under the SEC Investment Company Act of 1940.
Grantor Trust
This type of legal structure
distributes dividends directly to shareholders and allows investors to retain
their voting rights on the underlying securities within the trust. The original
securities in a grantor trust remain fixed and aren't rebalanced. Grantor trusts
are registered under the Securities Act of 1933. The streetTRACKS Gold Shares,
iShares Silver Trust, Merrill Lynch’s HOLDRs and the Rydex CurrencyShares follow this
format.
Exchange-traded Notes (ETNs)
ETNs are debt instruments that pay a return linked to the performance of a
single security or index. The operating
structure of ETNs is particularly suitable for specialized asset classes such as
commodities, currencies, and emerging markets.
Since ETNs are not required to distribute income
they are particularly tax-efficient for assets that pay ordinary income or short
term capital gains.
Under the current tax law, ETNs are treated and
taxed as prepaid contracts. This means investors incur tax consequences only
upon the sale, redemption, or maturity of their note. If held to maturity, the
future payment of the contract is dependent on the value of the underlying
benchmark index. ETNs are registered under the Securities Act of 1933.
Partnerships
Some
commodity linked products are operated as master limited partnerships (MLPs). Unit holders
are required to report their share of the MLP's income, gains, losses and
deductions on their federal income tax returns even if cash distributions are
not made. For annual tax reporting,
owners generally receive form K-1.
To sum up, not all ETF
structures are created equally. Depending on your unique investment goals, one
particular format may be more suitable to your needs than another.
Having a basic education about
your choices can go a long way towards making the right financial decisions.
