With U.S. stock and bond markets closed for a second consecutive day on Tuesday, October 30 because of Hurricane Sandy, it's an ideal time to look at exchange-traded products (ETPs).
This time, let's focus on the five main product structures that ETPs use.
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Open End Funds
The vast majority of traditional exchange-traded funds (ETFs) use an open-end structure. This product design is quite flexible and allows the usage of derivatives, portfolio sampling and securities lending. Dividends in open-end funds are immediately reinvested and usually distributed to shareholders either monthly or quarterly. The open-end structure is used by major ETF families like the iShares, State Street Global Advisors and Vanguard. Almost all open-end ETFs will follow either stock or bond indexes.
Unit Investment Trusts (UIT)
The UIT structure is considerably more restrictive compared to the open-end fund. For instance, it does not reinvest dividends, but instead holds them until they're paid out to shareholders. This creates a phenomenon known as "dividend drag." UITs are not allowed to loan securities in their portfolios and they must fully replicate their underlying indexes. Also, unlike open-end funds, UITs have expiration periods which typically last anywhere from a few years to decades. The SPDR Dow Jones Industrial ETF (DIA), PowerShares QQQ Trust (Nasdaq:QQQ), and the SPDRs S&P 500 (SPY) each use the UIT structure. UITs are generally very tax efficient.
This type of product structure is used by many popular single commodity ETPs like the SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV). Since these particular products own the physical metal and not the futures contracts on the metal, gains are taxed at ordinary income rates, which are currently 28%.
The grantor structure is also used by other commodity focused products like the PowerShares DB Commodity Index Tracking Fund (DBC). Like many other commodity ETPs, DBC uses futures contracts to obtain its commodities exposure. ETPs that use futures contracts are taxed each year even if you don't sell them. Capital gains are currently taxed at a hybrid rate of 60% long-term and 40% short-term gains.
Limited Partnerships (LPs)
The LP structure is used by many specialized and commodity focused ETPs like the United States Oil Fund (USO). Just like the previously mentioned DB Commodity Index Tracking Fund, USO uses futures contracts to obtain its oil commodities exposure. LPs that use futures contracts are taxed each year even if you don't sell them. Capital gains are taxed at a hybrid rate of 60% long-term and 40% short-term gains. At the end of each tax year, investors are sent a Schedule K-1.
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Exchange-Traded Notes (ETNs)
ETNs are debt instruments linked to the performance of a single commodity, currency or index. They have a set maturity date and they do not usually pay an annual coupon or specified dividend rate. ETNs can be traded or redeemed before the maturity date. If the note is held to maturity, the investor is paid the return of the note's underlying index, minus the annual expense ratio. ETNs carry issuer risk which is tied to the credit worthiness of the financial institution backing the ETN. If the issuer's financial condition deteriorates, it could negatively impact the value of the ETN, regardless of how its underlying index performs.
Gains on stock, bond and commodity ETNs are taxed at either long-term or short-term capital gains rates depending on how long you've held them. Typically these types of ETNs don't distribute dividends or interest income, so they are very tax-efficient. In 2007, the IRS ruled that currency ETNs should be taxed as bonds, regardless of whether the interest inside the note is automatically reinvested and not paid out until the note holder sells their ETN.
Which ETP structure is best? Before making any major investment decisions, it's crucial to clearly understand the strengths and weakness of each ETP type. Your success depends on it.