Keeping up with ETF Structures
Keeping up with ETF Structures
By Ron DeLegge, Editor - November 1, 2007
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.
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.
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.