When Structure Matters: ETF, ETN, Or Other?
As some financial advisors are now well aware, the term “ETF” is often used rather liberally to refer to a variety of different exchange-traded products that generally function in the same manner from the perspective of an investor. More accurately, ETFs can be described as a type of exchange-traded product, or ETP, an umbrella that also covers exchange-traded commodities, exchange-traded notes, and unit investment trusts (UITs). The nuances of these various structures might not make for the most lively discussion, but it is a worthwhile task for anyone who manages money for a living, as the seemingly minor differences between these types of products can often have a meaningful impact on risk taken on and bottom line returns realized [see 25 Things Every Financial Advisor Should Know About ETFs].
Most advisors are aware of the general differences between ETNs, which are debt instruments, and true ETFs, which feature no credit risk but can experience tracking error. That comparison, however, is only the tip of the iceberg when it comes to the differences of various products. These distinguishing characteristics are particularly important in certain asset classes, where the choice between ETF, ETN, UIT, or other type can potentially translate into hundreds of basis points in returns:
Master limited partnerships (MLPs) have become tremendously popular investment destinations in the late 2000s and early 2010s, in part because of the heightened interest in securities that offer meaty current yields. And exchange-traded products have become popular tools for accessing this corner of the domestic energy market; the 22 ETPs in the MLP ETFdb Category have aggregate assets of more than $20 billion.
Both AMLP and MLPI are linked to the same Alerian MLP Infrastructure Index, but these two tickers are hardly identical–as evidenced by a comparison of recent performance. The differences relates to the regulations surrounding MLPs, particularly when held within the ETP wrapper. AMLP is unique from other ETFs in that is treated as a C corp for tax purposes, meaning that it is required to accrue tax liabilities when the component securities appreciate in value. Acting as a partial offset is a potentially preferred treatment of distributions, which can enhance the bottom line, after-tax returns realized.
This is a complex issue that depends on a number of factors, including the nature of the account in which positions are held, holding period, and other tax circumstances that can vary from investor to investor [see MLP ETFs Fact & Fiction and Advanced ETF Topics: MLP ETPs]. But it’s one that is worth understanding fully; MLPs can be a very valuable component of a client portfolio, and it would be a shame to throw away returns by choosing the wrong product structure for tapping into this asset class.
Exchange-traded products have become a popular tool for accessing commodities within a portfolio, allowing investors to gain exposure to a potentially lucrative asset class without opening up a futures account. With dozens of broad-based commodity ETPs and resource-specific products to choose from, investors have no shortage of choices in this area. There are a number of factors to consider when picking a commodity ETP, such as the blend of individual natural resources and the roll strategy employed. Another key consideration is the decision between ETF and ETN, as the differences between these two extend beyond simple credit risk when it comes to commodities [see In Search Of The Best Commodity ETP].
Most commodity ETFs, such as the ultra-popular DBC, are actually structured as partnerships, and shareholders in these funds as partners. That means that these investors will get a K-1 at the end of the year, which some see as an administrative burden (though the legwork required can be accomplished pretty easily for many). Partnerships that hold futures contracts might also incur taxes annually for shareholders, meaning that a tax bill might come due even if a position was held throughout the year. In some cases, that can create an undesirable aftertaste in the wake of appreciations in value.
ETNs, on the other hand, are generally recorded on a form 1099, and can provide investors with more control over the timing of a tax event (i.e., tax liabilities are generally incurred when sold). ETNs also avoid the tracking error that can become material when futures contracts are regularly bought and sold, since notes don’t actually have an underlying portfolio but rather deliver the return indicated by movements in a benchmark’s value [see Futures Free Commodity ETFdb Portfolio].
Perhaps the best real life illustration of the impact of structure choice is a comparison between GSG (an ETF) and GSP (an ETN). Both products are linked to the S&P GSCI Total Return Index, but the ETN has generally delivered better returns thanks to the tax advantages and management efficiencies.
Investors can gain access to just about every major world currency through exchange-traded products; from the Chinese yuan to the Russian Ruble to the Canadian dollar, ETPs have the currency map pretty well covered. And in many cases there is more than one option for accessing a desired exchange rate, with the multiple products set apart by structural details. And once again, there are tax consequences to consider [see Currency ETN Investing: Highlighting More Complex Options].
WisdomTree offers a suite of true 1940 Act ETFs; these actively-managed products are generally taxed at capital gains rates, and can be diversified across multiple counterparties [see Currency Exposure Matters For ETF Investors]. The suite of Rydex CurrencyShares funds, on the other hand, are grantor trusts that hold foreign bank deposits and as such may concentrate counterparty risks. Gains in grantor trusts are also generally taxed as ordinary income.
Some currency ETPs are structured as ETNs; gains and losses in these securities will be treated as ordinary income at time of maturity, and single currency ETNs will generally recognize current income. According to the IRS, single currency ETNs are debt for tax purposes, meaning that any interest accrued will result in a tax liability, even if no distribution is made.
Disclosure: No positions at time of writing.