The exchange-traded fund (ETF) is a relatively new investment vehicle, hitting the market in 1993. A fund company can create ETFs when it is awarded specific exemptions from the Investment Company Act of 1940, a law enforced by the Securities and Exchange Commission (SEC) that governs companies offering investment funds to the public. Typically, a fund company must be awared three exemptions from the Investment Company Act of 1940 before the prospective ETFs are allowed to be sold on the market. These exemptions relieve ETFs of the following:

  • the requirement for funds to be individually redeemable
  • the requirement that funds cannot be traded at a negotiated price
  • the disallowance of funds to be traded as in-kind transactions

Some ETF issuers have requested exemption from other rules that usually apply to mutual funds. Up to this date (2005), no ETF issuers have been awarded the request for exemption from the requirement to pay out dividends collected from securities held in their funds. Some ETFs, however, have been granted permission by the SEC to reinvest the proceeds from dividends in ETF holders' accounts. (Costs of running an ETF are subtracted from dividends to be paid to ETF holders at least annually.) Dividends received or reinvested are taxed as personal income to the ETF unit holders. In the case of ETFs that realize a capital gain, the gain is passed onto the holders of the ETF funds, and also taxed as personal income.

So, as of 2005, the SEC has not granted any exemptions to laws that require distribution of income on a fund's holdings. However, an investment company can deduct its expenses for running the ETF from distributions it receives on its holdings. That is, the investment company can deduct its business costs of running the ETF from the money it generates on the ETF's funds.

Though there aren't any ETFs that are exempt from the requirement to make distribution payments to the fund's shareholders at least annually, ETFs are still developing. As securities laws are constantly changing, it is possible that future ETFs may be exempt from distribution requirements.

For more information on ETFs check out our An Inside Look At ETF Construction.

  1. Do ETFs pay capital gains?

    Learn about exchange-traded funds (ETFs), which can generate capital gains for their shareholders due to occasional and substantial ... Read Answer >>
  2. What exactly is an ETF portfolio?

    Learn what exchange-traded funds (ETFs) are and their advantages to investors, what a portfolio of ETFs is, and discover ... Read Answer >>
  3. Besides stocks, what other asset classes can I invest in through ETFs?

    Discover the extremely far-reaching range of investment asset classes that are available to investors through exchange-traded ... Read Answer >>
  4. What companies are positioned to grow from the popularity of ETFs? (VHT, DSUM)

    Discover reasons for the growing popularity of exchange-traded funds (ETFs) and some of the types of companies benefiting ... Read Answer >>
Related Articles
  1. Investing

    A Look At the Growth Of the ETF Industry

    Explore the phenomenal growth rate of the ETF industry, and learn some of the principal reasons why ETFs are projected to continue to grow at a rapid pace.
  2. Investing

    When Is the Right Time to Change From Mutual Funds to ETFs

    Find out how to determine when it's the right time for you to switch from mutual funds to ETFs, including the benefits of ETFs and who they are best for.
  3. Investing

    The Benefits Of ETF Investing

    Exchange-traded funds provide unique opportunities for investors. Find out how.
  4. Investing

    The Advantages of ETFs Compared to Index Funds

    With the ongoing ETF boom, ETFs gain more variety and increased competition in the market leads to further investors' advantages compared to index funds.
  5. Investing

    5 Reasons to Pick ETFs Over Mutual Funds

    Discover five reasons why average investors and sophisticated hedge funds choose ETFs instead of mutual funds to meet their investment goals.
  6. Investing

    5 ETFs Flaws You Shouldn't Overlook

    Despite their popularity, exchange traded funds have some drawbacks that investors should know about.
  7. Investing

    4 Things to Know Before Choosing an ETF

    ETFs are a low-cost way to get exposure to different markets. But they're not all the same. Investors should research the following key information regarding the ETF before buying it.
  8. Financial Advisor

    What All Investors Should Know About ETFs

    ETFs have become popular for their versatility and variety, but that doesn't mean they're always the right choice and that they're all created equal.
  9. Investing

    How To Avoid Expensive ETFs

    Discover four tips for avoiding expensive ETFs. Learn why expense ratios should be low and how to prevent your investment from costing you come tax time.
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Index ETF

    Exchange-traded funds that follow a specific benchmark index ...
  3. Dividend Drag

    A disadvantage of the dividend structure of unit trust exchange-traded ...
  4. Stock ETF

    A security that tracks a particular set of equities, similar ...
  5. Dividend ETF

    Any exchange-traded fund that seeks to provide high yields by ...
  6. Passive ETF

    One of two types of exchange-traded funds (ETFs) available for ...
Hot Definitions
  1. Assets Under Management - AUM

    The market value of assets that an investment company manages on behalf of investors. Assets under management (AUM) is looked ...
  2. Subprime Auto Loan

    A type of auto loan approved for people with substandard credit scores or limited credit histories. There is no official ...
  3. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  4. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
  5. Passive Management

    A style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. ...
  6. Series 7

    A general securities registered representative license administered by the Financial Industry Regulatory Authority (FINRA) ...
Trading Center