What is an ETF?

Over the last decade, the ETF emerged as one of the most popular investment vehicles. “ETF” stands for exchange-traded fund, which is a type of security that tracks an index, bonds, commodities, currencies, or a mix of various asset classes.

With respect to their portfolios, investors typically look to strategically allocate their capital into tax-efficient investment vehicles. One of those vehicles is the ETF, which is lauded for its tax efficiency.

 Composition and Creation of an ETF

Because it is a type of fund, the ETF is often compared to the mutual fund when weighing the pros and cons of various investment vehicles. The ETF owns underlying assets and divides ownership of those assets into shares.

These shares can be bought and sold on a major exchange. Furthermore, because of this flexibility, they can be traded intraday.

An ETF shareholder is also entitled to income earned through dividends. In the event the fund is liquidated, ETF shareholders may also receive a portion of its residual value, which is the value determined at the end of an asset’s useful life.

The process of creation and redemption is what regulates the supply of ETFs. This process will involve an authorized participant (AP) who can redeem shares of an ETF via sale to the fund’s sponsor.

The authorized participant comprises a part of a larger ecosystem for ETFs. Click here for more information on this ETF ecosystem.

Market demand will be the primary determinant for the amount of redemption and creation activity. Demand for the ETF will also drive the price of its shares, which in turn, determines whether the ETF is trading at a discount or premium relative to the value of its underlying assets.

As mentioned, because shares of ETFs are bought and sold on a major exchange, investors can trade them through online or traditional brokers.

Legal Structure of an ETF

The tax implications for ETFs can also vary according to their legal structure. A tax professional can help an investor navigate through the tax ramifications for each type of ETF structure.

Seven Types of ETF Structures:

  1. Open-end funds: this structure is typically used for stock and bond asset classes.
  2. Unit investment trusts: typically used to track broad asset classes.
  3. Grantor trusts: typically used for physical commodities and currencies.
  4. Exchange-traded notes: don’t hold underlying assets, but contain prepaid forward contracts.
  5. Partnerships: unincorporated business entities that elect for taxation as a partnership.
  6. C Corporations: used to access specific types of partnerships as well as other special purpose vehicles (SPVs).
  7. Exchange-traded managed funds: meld the active component of mutual funds with the intraday trading flexibility of an ETF.

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.

Tax Efficiency of an ETF

As mentioned, shares of an ETF are simply bought and sold through an exchange. Mutual fund shares are bought and sold directly through the mutual fund company, so the actions of other fund investors can affect an individual investor’s tax liability.

In essence, an individual tax investor doesn’t have control of the actions of his or her fellow mutual fund investors. In addition, a mutual fund manager must sell a portion of the fund’s holdings for shares redeemed, which could result in capital gains.