Exchange traded funds (ETFs) recently hit a very important milestone: as of the time of writing, ETFs now hold more than $3 trillion in investor assets. Investors – both large and small – continue to embrace the fund type as a way to build out their portfolios. And there’s plenty to like about them.
However, calling them a “fund type” is a tad bit misleading.
The truth is, there is more than one fund type that makes up the world of ETFs, and most investors are blissfully unaware of the structure used by their respective ETF holdings.
That’s a slight problem. While ETFs’ creation/redemption mechanism is the same, a number of different outcomes for various items can result depending on what structure an ETF uses – from taxes to how dividends are treated. Even when two ETFs are tracking a similar asset class or sector, structure matters.
Luckily, here at ETFdb, we’ve broken down the most common ETF structures and what they might mean in regards to your bottom line.
Open End Funds
The vast bulk of ETFs fall under the banner of open end funds. Created by the Investment Company Act of 1940 – and having protection under the Securities Act of 1933 and the Securities Exchange Act of 1934 – open end funds are what we traditionally think of when talking about mutual funds.
Open end funds are basically regulated investment companies that meet certain Internal Revenue Service standards when it comes to taxes. As pass-through entities’ income and capital gains are distributed to shareholders and taxed at the shareholder level, the ETF itself doesn’t pay taxes. Another major point of open end funds is that dividend and interest received from the fund’s holdings can be immediately reinvested. Derivatives, portfolio sampling, and securities lending can be utilized in an open end fund’s portfolio.
Unit Investment Trusts (UIT)
Some of the first ETFs on the marketplace – the PowerShares QQQ Trust (QQQ ), and the S&P 500 SPDR (SPY ) – are structured as unit investment trusts (UIT). Like open end funds, UITs fall under the banner of the Investment Company Act of 1940. However, there are several differences between the two. Much of that difference comes down to the fact that UITs do not have boards of directors or investment advisers; they represent static investment portfolios, which are great for transparency and low costs. You know exactly what you are getting – which is the reason why UITs were selected by early ETF issuers in the first place.
However, the disadvantages come down to dividends. Unlike open end funds, UIT dividends are not allowed to be reinvested, which means the fund just holds them as cash. That can create a “cash drag” during rising markets. Additionally, securities lending and derivatives are not able to be used by UITs. That can cause UITs to underperform open end versions of the same fund, albeit slightly. Technically, UITs have a dedicated end date.
Typically, ETFs that physically hold an asset are structured as grantor trusts. Often, these assets are either precious metals or currencies. The popular iShares Silver Trust (SLV ) or CurrencyShares Euro Trust (FXE ) are structured as grantor trusts, since they hold silver bullion and euros in a vault on behalf of investors. The key word here is “behalf”: investors in grantor trusts are direct shareholders of the underlying assets, rather than the fund owning them. As a result, investors are taxed as if they directly own the gold or currency. In the case of these two asset classes, that means paying capital gains are currently taxed at a hybrid rate of 60% long-term and 40% short-term gains.
Limited Partnerships (LPs)
Similar to grantor trusts, ETFs structured as limited partnerships (LPs) generally focus on commodities. But instead of physically holding gold, they use futures contracts or other derivatives to meet their mandates. When it comes to taxes, partnerships are essentially pass-through entities that avoid double taxation at both the fund and the investor level. The income, as well as realized gains and losses, from a partnership ETF flow through directly to investors, who then pay the tax on their share of partnership. The issue here is that investors may owe taxes on the LP even if they have a loss on the shares, based on the underlying investment gains inside the fund. These gains and losses will be spelled out on a K-1 statement – not a 1099 form – come tax time. Early filers will need to wait, since K-1s arrive at the beginning of March.
Exchange Traded Notes (ETNs)
Exchange-traded notes (ETNs) are kind of a weird bird when it comes to ETFs: ETNs are really bonds in disguise. They are forward contracts that promise to pay investors the return of an index or asset class at a later date. Investors buying an ETN become unsecured creditors of the issuing bank and need to realize that ETNs come with credit risk. Meaning that if the issuer files for bankruptcy, investors in an ETN will need to wait in the bankruptcy line to get their investment back.
They were originally created as a way to access hard to reach asset classes – master limited partnerships, currencies, and emerging market stocks – since ETNs don’t actually own anything. They just track the underlying index’s returns with the idea of providing that return to investors. ETNs will have a set closing date and will liquidate when it reaches that point.
In recent years, several ETFs have elected to be taxed as C corporations (C corps). A C corp is basically any corporation that is taxed separately from its owners. Really, 99% of all the stocks traded are C corps. In terms of ETFs, the structure is being used as a way to provide access to master limited partnerships (MLPs) and other special purpose vehicles (SPVs). Current regulations prevent open end funds and UITs from holding more than 25% of their portfolios in MLPs. By registering as C corps, ETFs can get around the regulation and hold the asset class.
The problem here is that ETFs that use this structure are taxed as corporations. This means the fund will pay taxes, then investors will pay taxes on dividends and gains.
Exchange-Traded Managed Funds (ETMFs)
The latest innovation and fund structure is what’s called exchange-traded managed funds. ETMFs seek to combine the active appeal of regular mutual funds with the intraday tradability of all the other ETF structures. ETMFs are not required to disclose their holdings daily, like regular ETFs, but quarterly, like mutual funds. Also similar to mutual funds, the ETMFs will true-up their net asset value (NAVs) at the day’s end. Without knowing the NAV, quotes for ETMFs are priced at amounts over or under the potential NAV based on supply and demand, so investors could pay more or less than NAV depending on demand.
As for taxes, ETMFs should function like regular open end ETFs. However, with the product being so new, the tax situation is really unknown.
The Bottom Line
ETFs continue to surge in popularity, but they vary in a multitude of ways – especially when it comes to how they are structured. For investors, understanding how the funds they own are legally structured can mean the difference between great gains and a nasty tax surprise.
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