A Look at the Structures of ETFs

Exchange-traded funds, better known by their acronym ETFs, are investment funds that have become increasingly popular in recent years. This week we take a look at four main ways they are structured and some differences among them.

In dollar terms, more than 30 percent of equity trading in the U.S. are now ETFs. As mutual-fund managers have as a group struggled to beat market indices, investors are increasingly leaving them for ETFs, which tend to be more passively managed and charge lower fees.

The first ETF—SPDR S&P 500 ETF (NYSE: SPY) began trading in 1993. By the end of the first half of this year, there were more than 2,000 ETFs in the U.S. alone. While the earliest ETFs started as passively managed funds that track certain stocks indexes, now there are ETFs that track different asset classes such as commodities and bonds, which offer retail investors an easy way to invest in assets other than stocks.

ETFs are structured in four main ways.

The vast majority are structured as open-end funds. This structure is favored by ETFs whose primary objective to provide investors exposure to stocks and bonds. The open-end fund ETF is regulated under the Investment Company Act of 1940, which defines the limitations and responsibilities placed on open-end funds that offer investment products to the public. Thus, shareholders of this type of ETF are protected under this law, as well as the Securities Act of 1933 and the Securities Exchange Act of 1934.

These ETFs are eligible for automatic dividend reinvestment, derivatives and securities lending. For those not familiar with securities lending, this is when an ETF lend the shares of stocks it holds to short sellers, who in return post collateral and pay the ETF a fee. The profits from this practice—which does involve a small amount of risk—can be partially or entirely passed down to shareholders.

The second type of ETF is a unit investment trust (UIT). UITs do not actively trade its underlying securities. Rather, it purchases a fixed portfolio. There are only a small number of UITs around, and they are typically used to track a broad asset class, like a large stock index. The aforementioned SPY is one such example of a UIT.

This type of ETF has no investment managers, and thus typically keeps costs low. On the other hand, it cannot engage in the derivatives trading and securities lending practices. UIT shares are redeemable, but only in very large blocks and thus not applicable to most retail investors.

UIT and open-end ETFs are the only two types of ETFs that enjoy the legal protection noted above. Both open-end ETF and UITs only have limited access to alternative assets so investors looking to invest in assets such as commodities have to look elsewhere, such as a grantor trust.

The grantor trust structure is typically used by ETFs that invest in commodities or currencies because they are required to hold a fixed (unmanaged) portfolio. For example, the popular gold and silver ETFs, SPDR Gold Shares (NYSE: GLD) and iShares Silver Trust (NYSE: SLV) are both grantor trusts. Shareholders in a grantor trust directly own a proportionate amount of the assets in the trust. In the case of precious metals grantor trusts such as GLD and SLV, profit from the sale of shares are taxed as collectibles rather than capital gains.

The fourth type of ETF is an exchange-traded note (ETN). ETNs are issued as forward contracts that promise to pay the return of a given index, net of the issuers’ expenses.

ETNs do not hold any actual assets. When you buy an ETN, you are essentially purchasing debt; although in this case the “principle” will fluctuate over time since the issuer promises to pay you at maturity whatever the return of a given index is. Since an ETN is essentially debt, the creditworthiness of the issuer should be carefully considered. ETNs are usually used for niche markets and because they promise to pay the return of a specific index, the problem of tracking errors faced by other ETFs is eliminated (net of expenses, of course).

Despite these structure differences, as a group ETFs offer the convenience and reach that have cause their popularity to soar and opened up many doors to investors. We caution our readers to tread carefully when considering ETFs that target overly narrow niches. But when managed prudently, ETFs can be an integral part of a well-diversified core portfolio.