- What they are: Uniquely structured investment funds that track broad-based or sector indexes, commodities and baskets of assets.
- Pros: Trade like stocks on regulated exchanges; diversity in a single investment; low expense ratios; tax efficient; some trade commission-free through participating brokers.
- Cons: Certain ETFs subject to contango; bid-ask spreads can be large; certain ETFs are taxed at a higher rate (such as gains on ETFs that hold physical precious metals).
- How to invest: ETFs trade just like stocks on regulated exchanges. You can trade online using your broker’s online trading platform, or by calling your broker’s trade desk to place orders.
Exchange traded funds, or ETFs, are uniquely structured investment funds that track broad-based or sector indexes, commodities and baskets of assets. With access to nearly any asset class or sector, ETFs offer exposure to markets that have traditionally been challenging for individual investors to tap into, such as commodities and emerging markets. Since the first exchange traded fund was introduced in 1993, ETFs have become increasingly popular because they:
- Are tax efficient investments
- Boast low expense ratios
- Can be sold short and purchased on margin
- Maintain inherent liquidity
- Offer diversity in a single investment
- Provide intraday trading access
- Trade just like stocks on regulated exchanges
Exchanged-traded funds and exchange-traded products (ETPs) use different product structures. When investing in an ETF, it is important to understand the fund’s legal structure and corresponding implications, including financial risks and tax treatment. This information is generally available in the fund’s prospectus. It should be noted that the term "ETF" is frequently used as a catchall for both ETFs and other exchange-traded products. ETNs, for example, are not actually ETFs but are similarly categorized. There are five types of structures for exchange-traded products, including ETFs: open-end fund, unit investment trusts, grantor trusts, limited partnerships and exchange-traded notes.
Most ETFs use an open-end structure. These funds must be registered with the Securities and Exchange Commission under its Investment Company Act of 1940, and there are no restrictions on the number of shares that the fund can issue. As long as there is demand, the fund can continue to issue shares. Any dividends are reinvested on the day of receipt and cash distributions are paid to shareholders each quarter.
Unit Investment Trusts (UITs)
The other primary ETF structure is a unit investment trust, or "UIT.” Also regulated by the SEC Investment Company Act of 1940, UITs are required to fully replicate their specific indexes while restricting investments in a single issue to 25% or less. A UIT holds its investments with little or no change for its duration. A UIT makes a "public offering" of a fixed number of units that are tradable on a secondary market. When a UIT is created, an expiration date is established; when the UIT terminates, any remaining securities are sold and any proceeds are paid to investors. Dividends are held until they are paid to shareholders, generally on a quarterly basis.
Grantor trust investment portfolios are fixed and cannot be changed at a later date. Dividends are immediately distributed to shareholders, and investors have the same voting rights as any other shareholder for each company in the trust’s portfolio. Grantor trusts can be tax efficient and investors can control taxes by deciding when to sell their shares. Many grantor trusts hold physical assets and own single commodities, such as the SPDR Gold Shares ETF (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV), while others invest in a portfolio of securities. Dividends are immediately distributed to shareholders.
Limited Partnerships (LPs)
A limited partnership, or an "LP,” is an alternative legal structure that is not an Investment Company within the meaning of the SEC Investment Company Act of 1940. The most well-known limited partnerships are the United States Oil Fund (NYSE: USO) and the United States Natural Gas Fund (NYSEArca: UNG). These funds, which invest through futures contracts, are taxed each year even if you still own the position; capital gains are taxed at the hybrid 60% long-term and 40% short-term rates. Dividends may or may not be reinvested.
Exchange-Traded Notes (ETNs)
Exchange-traded notes, or "ETNs,” are unsecured debt securities that pay a return linked to the performance of an individual commodity, currency or index. ETNs have a specified date of maturity that can be as long as 30 years or more. These investment products are subject to counterparty risk: the creditworthiness of the backing institution can negatively impact the ETN’s value, even if the underlying index performs well. Typically, ETNs do not pay dividends or annual coupons.
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