The term ETF is used by many investors to refer to a wide range of financial structures that aren't technically 1940 Act Exchange-Traded Funds. Many of the most popular ETFs included in our Free ETF Screener are technically Unit Investment Trusts (UITs), a type of security that functions in largely the same way as an ETF but features some structural nuances that impact the risk/return profile. .

Dividends

One primary difference between a straight ETF and an exchange-traded-UITsuch as the S&P 500 SPDR is how dividends are handled.

When a UIT receives a dividend from a component company, the fund managers will hold it in cash until the end of the quarter. Come the end of the quarter, collected dividends are paid out to investors holding units of the fund.ETFs that are not set up as UITssuch as the iShares S&P 500 Index ETF have the option to reinvest dividends immediately. This can provide favorable returns to investors during bull markets, as the reinvested dividends capitalize on rising stock prices.

When the market drops, however, UITs have the upper hand. By having the cash received from dividends on the sidelines, UITs are reinvesting that cash into declining stocks, which could result in an erosion of capital.

Tracking Error

UIT fund managers must replicate the underlying index at all times. For example, the S&P 500 SPDR must be invested in all 500 stocks that compose the S&P 500 index to ensure the UIT precisely mimics the price movements of the actual index.An ETF that is actively managed can invest in multiple products in an attempt to re-create the performance of the underlying index or asset. This type of management can result in tracking errors at times the ETF may outperform or underperform the underlying asset.

The trading style of the trader or investor will determine which modelUIT or ETFthey should choose to trade. With a UIT there are likely to be no surprises outside of what happens to the index. ETFs that are more actively managed may have surprises not linked to market movements. An example of this occurs when the investments chosen to re-create the underlying asset don't accurately reflect the price changes in the underlying asset .

Over a long time-frame, slight deviations in performance relative to the underlying asset may be dismissed as inconsequential to the average investor. Large deviations, on the other hand, make it hard to determine what you are actually buying. Therefore, before you purchase an ETF, note how the ETF has performed historically relative to the benchmark index or asset it is meant to represent. A little homework up front can avoid a surprise down the road.

Active traders and options traders generally gravitate toward UIT productsThe S&P 500 SPDR, for example, has historically been the highest volume ETF/UIT product. These types of traders are looking for transparency and price action, which is linked to the index they have built their strategies on. If an ETF does not move lower (or moves too low) when the underlying index moves lower, it is very hard to develop an active or options trading strategy for such an instrument. UITs generally do not have this issue .

Share Lending

Share lending is a practice by which shares held within an ETF are lent out to other financial firms in exchange for an interest fee.UITs never lend out shares. The S&P 500 SPDRa UITtherefore, doesn't lend out any shares, but the iShares S&P 500 Index ETF does .

The percentage of share-lending profits paid into the fund is laid out in the investment prospectus; the iShares S&P 500 Index ETF re-invests 65%; the Vangard S&P 500 ETF re-invests 100% of share-lending profits back into the fund.

Fees and expenses erode profits over time, which means most ETFs and UITs will underperform their underlying index. Re-invested share-lending profits help diminish the gap in performance between the ETF and the index. In some years, it's possible for an ETF to more closely track an index than a UIT, simply because of the profits generated by share lending help offset fees.

SPY vs. IVV

SPY and IVV have performed very similarly from 2008 through the end of 2011 and the table below shows the performance of each fund over four years. Returns include income from dividends and interest payments (applicable to IVV) and capital gains or losses; management fees and expenses have also been deducted.

Ticker 2008 2009 2010 2011
SPY -36.81% +26.37% +15.06% +1.89%
IVV -36.93% +26.42% +15.09% +1.86%
S&P 500 Index -37.00% +26.46 +15.06% +2.11%

While there are slight differences in the performance from year-to-year between SPY, IVV and the underlying S&P 500, the risk profiles of the investments are quite similar.

The Bottom Line

Despite their differences, the S&P 500 SPDRa UITand the iShares S&P 500 ETF, have performed similarly and share nearly the same risk profile. This may not always be the case. Each investment structure has advantages and disadvantages, which are often highlighted during varying market conditions. A UIT will be somewhat cushioned during market declines because dividends aren't reinvested.Unfortunately, UITs receive no income from share lending. Managed ETFs have the possibility of tracking errors, dividends are re-invested, and share-lending income can offset management fees and expenses. Thoroughly read the investment prospectus and view the past performance of the UIT/ETF relative to underlying index so you feel confident that you know what you are buying.

Disclosure: No positions at time of writing.
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