ETF Product Structures

Exchange-traded funds (ETFs) and related exchange-traded products (ETPs) can use various types of product structures. Each structure has its own unique advantages and disadvantages. Knowing the subtle differences can help you to make informed investment decisions.

Let’s examine five key product architectures.

Open End Funds

The vast majority of traditional ETFs follow an open-end structure. This product design is quite flexible and allows the usage of derivatives, portfolio sampling and securities lending. Dividends in open-end funds are immediately reinvested and usually distributed to shareholders either monthly or quarterly. The open-end structure is used by major ETF families like the iShares, State Street Global Advisors and Vanguard. Almost all open-end ETFs will follow either stock or bond indexes. While the open-fund structure is generally tax-efficient, it’s still a good idea to position tax inefficient asset classes like bonds or REITs into tax-deferred accounts.

Unit Investment Trusts (UIT)

The UIT structure is considerably more restrictive compared to the open end fund. For example, it does not reinvest dividends, but instead holds them until they’re paid out to shareholders. This creates a phenomenon known as “dividend drag.” UITs are not allowed to loan securities in their portfolios and they must fully replicate their underlying indexes. Also, unlike open-end funds, UITs have expiration periods which typically last anywhere from a few years to decades. The Dow DIAMONDS (DIA), PowerShares QQQ Trust (QQQQ), and the SPDRs S&P500 (SPY) each use the UIT structure. UITs are generally very tax efficient.

Grantor Trust

This type of product structure is used by popular single commodity ETPs like the SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV). Since these products own the physical metal and not the futures contracts on the metal, gains are taxed at ordinary income rates, which are currently 28%. The grantor structure is also used by other commodity focused products like the PowerShares DB Commodity Index Tracking Fund (DBC). Like many other commodity ETPs, DBC uses futures contracts to obtain its commodities exposure. ETPs that use futures contracts are taxed each year even if you don’t sell them. Capital gains are currently taxed at a hybrid rate of 60% long-term and 40% short-term gains. While it’s rare, some ETPs that invest in stocks like the HOLDRS use the grantor trust format. All of the HOLDRS are concentrated baskets of stocks that follow no index. The original stocks installed inside the trust remain fixed and aren’t rebalanced.

Limited Partnerships (LPs)

The LP structure is used by the United States Oil Fund (USO). Just like the previously mentioned DBC, this particular LP uses futures contracts to obtain its oil commodities exposure. LPs that use futures contracts are taxed each year even if you don’t sell them. Capital gains are taxed at a hybrid rate of 60% long-term and 40% short-term gains. At the end of each tax year, investors are sent a Schedule K-1.

Exchange-Traded Notes (ETNs)

ETNs are debt instruments linked to the performance of a single commodity, currency or index. They have a set maturity date and they do not usually pay an annual coupon or specified dividend rate. ETNs can be traded or redeemed before the maturity date. If the note is held to maturity, the investor is paid the return of the note’s underlying index, minus the annual expense ratio. ETNs carry issuer risk which is tied to the credit worthiness of the financial institution backing the ETN. If the issuer’s financial condition deteriorates, it could negatively impact the value of the ETN, regardless of how its underlying index performs.

Gains on stock, bond and commodity ETNs are taxed at either long-term or short-term capital gains rates depending on how long you’ve held them. Typically these types of ETNs don’t distribute dividends or interest income, so they are very tax-efficient. In 2007, the IRS ruled that currency ETNs should be taxed as bonds, regardless of whether the interest inside the note is automatically reinvested and not paid out until the note holder sells their ETN.

Popular ETF/ETPs by their Product Structure

Open End Fund
iShares Barclays Aggregate Bond Fund (AGG)
iShares MSCI Brazil Index Fund (EWZ)
Technology Select Sector SPDR (XLK)
SPDR Barclays Capital 1-3 Month T-Bill ETF (BIL)
Vanguard REIT ETF (VNQ)
Unit Investment Trusts
Dow DIAMONDS (DIA)
MidCap SPDRs (MDY)
PowerShares QQQ (QQQQ)
SPDR S&P 500 (SPY)
Grantor Trusts
Biotech HOLDRS (BBH)
iShares Silver Trust (SLV)
PowerShares DB Commodity Index Tracking Fund (DBC)
SPDR Gold Shares (GLD)
Partnerships
United States Oil Fund (USO)
United States Natural Gas Fund (UNG)
Exchange-Traded Notes/ETN
iPath DJ AIG Commodity Index Total Return (DJP)
iPath S&P GSCI Crude Oil Total Return Index (OIL)
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