A:

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.

RELATED FAQS
  1. Should I invest in ETFs or index funds?

    Learn advantages to investing in exchange-traded funds, or ETFs, and index funds, and decide whether to include them in your ... 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

    5 ETFs Flaws You Shouldn't Overlook

    Despite their popularity, exchange traded funds have some drawbacks that investors should know about.
  3. 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.
  4. Investing

    Advantages and Disadvantages Of ETFs

    You've probably heard that ETFs are better than mutual funds, but you need to consider all aspects before investing.
  5. 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.
  6. Financial Advisor

    What Your Clients Must Know About ETFs

    Like any investment, ETFs come with some fine print. Here is what advisors should reveal to their clients about these hugely popular products.
  7. 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.
  8. Investing

    4 Ways to Evaluate ETFs Before Buying

    Learn four areas in which to evaluate an ETF investment to be sure that the investor has a clear understanding of the security being purchased.
  9. Financial Advisor

    Advising FAs: Explaining ETFs to a Client

    Exchange traded funds (ETFs) have exploded in popularity with both investors and professionals for several reasons, and their growth shows no sign of slowing.
RELATED TERMS
  1. ETF Of ETFs

    An exchange-traded fund (ETF) that tracks other ETFs rather than ...
  2. Exchange-Traded Fund (ETF)

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

    Exchange-traded funds that follow a specific benchmark index ...
  6. Dividend ETF

    Any exchange-traded fund that seeks to provide high yields by ...
Hot Definitions
  1. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an ...
  2. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  3. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  4. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  5. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  6. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
Trading Center