Other Types of ETFs & ETNs

ETFs are now entering the market that employ "active" management, hedge fund replication, commodity, currency, or other alternative index approaches, but for the most part, they all share the same exchange traded benefits of index ETFs. These benefits include transparency, tradability due to their exchange traded nature, and to varying degrees, tax-efficiency though the ETF structure's creation and redemption processes. All of these products have unique risks, so it is important to read the prospectus of any of these products to completely understand the nuances of each ETF.

Actively Managed ETFs

There is some debate as to what constitutes an "active" ETF. Most ETFs attempt to mimic the performance of an un-managed or passive index, currency basket, commodity, etc. As with the case with Actively Managed Mutual Funds, Actively Managed ETFs attempt to employ an active management approach by using a quantitative or qualitative methodology to select an ETF's holdings.

In a quantitative investment methodology, the ETF's holdings are often driven by a computer model that might typically address exposure to a given benchmark or market segment (mid cap US stocks for instance) by ranking these holdings by cash flow, earnings, price earnings ratios, etc., and include the top ranked securities for inclusion in the ETF.

In a qualitative or fundamental approach, an investment manager will use publicly available or proprietary research, meetings with the management of public companies, and other factors in determining which securities are best suited for the fund. As such, these actively managed ETFs don't intend to mirror the performance of a given index, they intend to outperform a given benchmark or market segment. As with actively managed mutual funds, the investor has to weigh the potential benefits of outperforming the benchmark index vs any potential under-performance. The investor's decision would normally be based on their view that the ETF investment manager can select the securities that will lead to outperformance vs its benchmark, net of the ETF's fees, over a given market cycle.

Commodity & Currency:

Commodity ETFs and ETNs, sometimes referred to as "Exchange Traded Products" (ETPs) vary widely. Some of these products attempt to replicate a single commodity, such as Oil or Gold. Yet, several products attempt to replicate a diversified commodity index such as the Dow Jones UBS Commodity Index in which the index consists of exposure to a multitude of commodities such as Oil, Precious Metals, Livestock, etc.. Investors should be aware that in most Commodity ETFs, any interest income in the fund is paid out and taxed as regular income. Second, the funds are "marked-to-market" at the end of the year, meaning the IRS treats the funds as if you sold them on December 31... even if you didn't. If the fund performed positively since your purchase date, you are liable for capital gains taxes, with 60% treated as long-term gains and 40% treated as short-term gains. Third, some commodities future markets are inherently volatile and create a challenge to ETF issuers to maintain correlation to the underlying commodity price. [I don't understand this sentence eliminated and added clarity above], Finally, it's important to note that some commodity funds are structured as leveraged or inverse ETFs and ETNs. These products allow yet another way for investors to expose their portfolio to commodities, but naturally require a higher risk threshold on the part of the investor (see leveraged and inverse ETFs above). Currency ETFs/ETNs are yet another category of exchange traded products. As with the commodity products, these products may track a particular currency or a basket of different currencies relative to the dollar, or even against other currencies. Investors should be aware of the tax treatment of Currency products structured as ETNs (see ETN risks above), but these products can offer investors a viable way to provide currency exposure for their portfolio. These products have risks similar to the currency risks as well as the risks of currency exchange rates. Please consult the prospectus for the particular ETF/ETN at issue to learn more about how the product is managed.

Alternative Investments

Some ETFs and ETNs might be characterized as Alternative Investments in that they pursue "non-traditional" investment strategies. Examples of these products include ETFs/ETNs that track the CBOE volatility index (VIX) or Hedge Fund Replication strategies. In such cases, the use of Alternative Investments should be used by sophisticated investors who understand the risks. In the case of a hedge fund replication strategy, for example, the ETF could include Emerging Market ETFs, Leveraged/Inverse ETFs, Commodity ETFs as well as lower volatility products like short term Treasury ETF. The overall intent is to give investors access to a sophisticated hedge fund strategy while delivering a low or non-correlated investment approach. Some of these alternative products may be organized as a "Partnership" and investors should be aware that they will need to file a K-1 as part of their tax filing. As with other ETFs, investors should read and understand the prospectus or offering materials for these investments.

Foreign and Cross-Listed ETF/ETNs

Many ETFs (including ETNs and ETPs) are "domiciled" in Europe, Latin America, Asia, etc. At this time, these ETFs are difficult for a US investor without access to international trading capability. If an investor were to purchase an ETF domiciled on a UK exchange for instance, the product will typically trade in Euros. This would generally mean that in addition to the market or structural risks discussed above (see leveraged and commodity ETF sections for example) a US investor looking to trade a foreign ETF would also be taking on the risk of trading in foreign markets as well as the currency risk associated with the foreign ETF's currency vs the US dollar.

Another evolving trend is for a US ETF to "cross-list" on a foreign exchange. This would entail a US product that trades on the US exchanges (NASDAQ/NYSE ARCA), but also trades on a foreign exchange in the foreign exchange's currency. Typically, cross-listing is intended to give the sponsor of the ETF a broader potential investor base and increase the amount of assets under management, but it can also introduce currency and other risks for the investor. As with other ETFs, investors should read and understand the prospectus or offering materials for these investments.