Other Types of ETFs, ETNs and ETPs

There are new variations of Exchange Traded Products coming to market on a regular basis. Some Exchange Traded Funds (ETFs) that now use "active" management, and hedge fund replication, rather than index-based passive management are becoming more mainstream. In addition, Exchange Traded Products (ETPs) that look to track commodities and currencies have grown in popularity. For the most part, however, they share similar exchange-traded benefits of index ETFs, including transparency, intraday trading, conditional trading, and varying degrees of tax-efficiency. All of these products have unique risks, so it is important to read the prospectus of any of these products you consider.

Actively Managed ETFs

There is some debate as to what constitutes an "active" ETF. Most ETFs attempt to track the performance of an unmanaged or passive index, currency basket, commodity, etc. As is the case with actively managed mutual funds, actively managed ETFs attempt to employ an active management approach by using a quantitative or qualitative methodology in selecting their ETF's holdings.

With a quantitative investment methodology, the ETF's investments are selected using a computer model that might typically address exposure to a given benchmark or market segment (mid cap US stocks, for instance) and ranks holdings in that segment by cash flow, earnings, price-earnings ratios, and more.

Using a qualitative or fundamental approach, an investment manager analyzes 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 seek to track the performance of a given index, but to outperform it.

As with actively managed mutual funds, investors should weigh the potential benefits of outperforming the benchmark index vs. any potential underperformance. An investor's decision would normally be based on their assessment as to whether the ETF investment manager can select securities that will lead to outperformance vs. the benchmark, net of the ETF's fees, over a given market cycle.

Commodity ETFs, Exchange Traded Notes (ETNs) and other Exchange Traded Products (ETPs)

Commodity ETFs, ETNs and ETPs vary widely. Some attempt to track a single commodity, such as oil or gold. Yet, several products attempt to track a diversified commodity index such as the Dow Jones UBS Commodity Index in which the index consists of exposure to numerous commodities such as oil, precious metals, livestock, etc. Certain commodity ETPs track the spot price of commodities by holding physical stockpiles of the commodity itself, while others attempt to track the futures prices of commodities through the use of derivatives like futures.

Note: Investors should be aware that some commodities futures markets are inherently volatile which may create a challenge to ETP issuers to maintain correlation to the referenced commodity's spot price.

Currently, the majority of commodity ETPs track a commodity, basket of commodities, or commodity index through the use of derivatives such as futures contracts. The performance of commodity-futures linked ETPs can deviate significantly from the performance of the referenced commodity or commodity index, especially over longer periods. Contango is a specific commodity market condition that can contribute to the divergence from a commodity's spot price performance exhibited by certain commodity futures-linked ETPs. Contango occurs when contracts for more-distant delivery of a commodity are more expensive than contracts approaching expiration. As contracts are sold by the ETP prior to expiration, and contracts with more distant delivery dates are purchased, the result is a loss or negative roll yield (commodity ETPs will sell their futures contracts with the nearest delivery date to avoid taking physical delivery of the commodity). Ultimately, this negative roll yield may lead a systematic erosion of the ETP's value over time. Backwardation is the opposite market condition to contango. When a market is in backwardation, the commodity futures contracts sell for a lower price than the current market or spot price of the commodity. It is important to note, however, that backwardation does not necessarily lead to positive returns. Over time, any performance differential can be magnified if a specific condition, such as contango or backwardation, persists in the market for a given commodity.

From a tax perspective, investors should be aware that, in most commodity ETPs, any interest income in the fund is paid out and taxed at ordinary income rates. 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 did not. 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. Investors in certain Precious Metals ETFs should be aware that due to the structure of these investments and under current tax law, gains recognized from their sale held for more than one year may be taxed at a maximum federal income tax rate of 28%, rather than the 15% rate applicable to other long-term capital gains for many investors.

Finally, it is 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/ETNs for more). Please consult the prospectus for the particular ETF/ETN/ETP at issue to learn more about specific risks and how the product is structured and managed.

 

Note: Purchasing an ETP that holds Physical Precious Metals in a Retirement Account

The direct purchase of precious metals and other collectibles in an IRA or other retirement plan account can result in a taxable distribution from that account (except as specifically provided under IRS rules). If precious metals or other collectibles are held in an ETF or other underlying investment vehicle, you should first confirm that such an investment is appropriate for a retirement account by reviewing the ETF prospectus or other issuing documentation and/or checking with your tax advisor. Some ETF sponsors include a statement in the prospectus that an IRS ruling was obtained providing that the purchase of the ETF in an IRA or retirement plan account will not constitute the acquisition of a collectible and as a result will not be treated as a taxable distribution.

Currency ETFs, ETNs and ETPs

Currency ETFs, ETNs and ETPs 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 (described in the ETN section). However, these products can offer investors a viable way to provide currency exposure for their portfolio. These products have some risks similar to the commodity products mentioned above because some hold the physical currency while other products use futures to try and track the returns of the currency as explained in the commodity section. In addition, currency ETPs have the risk of currency exchange rates. Please consult the prospectus for the particular ETF/ETN/ETP at issue to learn more about specific risks and how the product is structured and managed.

ETFs/ETPs Structures

What are commonly referred to as Exchange Traded Funds are probably better described as Exchange Traded Products. Here a quick breakdown of the different structures that currently exist:

Open-End Mutual Fund

This is an SEC-registered investment company under the Investment Company Act of 1940. This type of structure permits shares to be continuously issued and redeemed. The majority of ETPs are structured this way. With this structure, the portfolio is managed by an advisor and can hold many types of equity and fixed income securities, including derivatives. Capital gain and income distributions are governed by number of tax laws and dividends are allowed to be re-invested in the fund.

Unit Investment Trusts (UITs)

This is another type of SEC-registered investment vehicle under the Investment Company Act of 1940. The two main types of Unit Investment Trusts (UITs) are stock (equity) trusts and bond (fixed income) trusts. The portfolio of securities held by the UIT is managed by a trustee. Investors purchase units that represent an undivided ownership in the entire portfolio of securities held by the UIT. Capital gain and income distributions are not permitted to be re-invested in the trust.

Grantor Trust

Grantor Trusts are not registered under the Investment Company Act of 1940 and are not subject to the same regulatory requirements as mutual funds. This structure is used mostly with Holding Company Depository Receipts (HOLDRS), commodities and currencies. Exchange Grantor Trusts hold a fixed portfolio of assets and issues shares based on the value of those assets. The trust's holdings are locked; they cannot be added to or subtracted from at a later date and they are not rebalanced. Investors in grantor trusts are considered shareholders of the underlying assets held by the trust.

Partnership Structure

Some ETPs are organized as partnerships, rather than corporations or trusts. This structure is used mostly for commodity ETPs. A partnership can hold derivatives and securities. Because partnerships are pass-through entities for tax purposes, the activities of the ETP get passed on to shareholders. This may result in investors incurring tax on profits without having received a distribution. Funds generally aren't required to distribute cash corresponding to an investor's partnership taxable income. Thus, investors may have a tax liability that will have to be paid from other sources. Partnerships issue a Schedule K-1 (Form 1065) rather than a Form 1099 form for tax purposes. It lists the partner's share of income, deductions, credits, etc. Speak with your tax advisor to determine how this may affect you.