There are many inherent advantages of exchange-traded funds (ETFs), and a lot of them will depend on the type of legal structure involved. Financial advisors should understand these types of legal structures to determine how ETFs can be useful for their clients’ portfolios.
The tax efficient nature of ETFs make them a prime alternative when compared to mutual funds. However, the tax implications for ETFs will also vary according to their legal structure.
Seven types of ETF structures:
- Open-end funds
- Unit investment trusts
- Grantor trusts
- Exchange-traded notes
- Partnerships
- C Corporations
- Exchange-traded managed funds
1. Open-End Funds
The majority of ETFs are structured as open-end funds, which fall under the regulatory measures of the Investment Company Act of 1940. These types of ETFs typically provide investors exposure to the most common assets, which are stocks and bonds.
However, open-end funds have limited access to other asset classes like commodities so diversity is limited. However, income received from dividends and interest can be reinvested in an ETF immediately.
From a tax liability standpoint, income and capital gains can go directly to the shareholders if the open-end fund meets Internal Revenue Service standards as a pass-through entity. This avoids the double taxation aspect of a corporation.
2. Unit Investment Trusts (UITs)
According to Investopedia, a unit investment trust is “an investment company that offers a fixed portfolio, generally of stocks and bonds, as redeemable units to investors for a specific period of time.” UITs are used by ETFs to track broad asset classes and unlike open-end funds, their investment ability is limited.
Furthermore, UITs do not reinvest dividends. Instead, they are held until it’s time to pay the shareholders in the fund.
However, from a tax perspective, UITs are treated like open-end funds in that they feature pass-through taxation. Since there are no board of directors or investment managers in UITs, that also makes them less costly in lieu of less investment flexibility.
3. Grantor Trusts
ETFs structured as grantor trusts typically invest in commodities or currencies. They are ideal for these types of assets since grantor trusts must hold a fixed portfolio.
Grantor trusts fall under more regulatory measures versus an open-end fund. In particular, they must meet the requirements set forth by the Investment Company Act of 1933 and 1934.
Because of this, ETFs structured as a grantor trust must provide additional financial disclosures.
Tax-wise, ETFs structured as grantor trusts look at investors as direct shareholders of the investments held in the fund. Therefore, investors are taxed directly.
4. Exchange-Traded Notes (ETNs)
ETFs structured as ETNs are prepaid forward contracts that promise to pay a specified sum equal to the return realized from an index. As such, ETNs do not contain holdings of any actual assets.
Individuals who invest in ETNs are subject to additional credit risk since the essentially become unsecured creditors of that ETN and have no regulatory protection under the Investment Company Act of 1940. Therefore, no assets can be sold to pay back creditors since ETNs don’t hold assets.
Very similar to a bond, an ETN has a maturity date where the investors is paid the returns, if any, of the index. ETNs are typically used to satisfy investors looking for exposure to niche markets like currencies, commodities and international assets.