Investors, both large and small, continue to embrace ETFs as a way of building their portfolios. However, those who define them as “type of fund” are expressing a rather misleading concept. The truth is, there is more than one type of fund that makes up the world of ETFs.
While the ETF’s creation / redemption mechanism is the same, a number of different results may arise for various elements depending on the structure used by an ETF, from taxes to the way dividends are treated. Even when two ETFs monitor an asset class or similar sector, the structure matters. Below are the most common ETF structures and what they could mean in relation to profits.
The overwhelming majority of ETFs fall under the open-end case history, which traditionally are mentioned when it comes to mutual funds.
Open funds are basically regulated investment companies that meet certain tax standards. Since pass-through entities’ revenue and capital gains are distributed to shareholders and taxed at shareholder level, the ETF itself does not pay taxes. Another important point of open funds is that the dividend and interest received from the fund’s holdings can be reinvested immediately. Derivatives, portfolio sampling and securities lending can be used in the portfolio of an open-ended fund.
Unit Investment Trust (ITU)
Some of the first ETFs on the market are structured as a unit investment trust (ITU). Like open funds, ITUs fall under the banner of the 1940 Investment Company Act. However, there are several differences, especially in the fact that ITUs do not have boards of directors or investment advisors, they represent static investment portfolios, they are excellent for transparency and low costs.
However, the disadvantages are reduced to dividends. Unlike open funds, UIT dividends cannot be reinvested, which means that the fund only holds them in cash. This can create a “cash drag” during emerging markets. In addition, securities and derivatives loans cannot be used by ITUs.
Typically, ETFs that physically hold an asset are structured as grantor trusts. Often these assets are precious metals or currencies. The popular iShares Silver Trust (SLV C +) or CurrencyShares Euro Trust (FXE A) are structured as grantor trusts in that they hold silver and euro bars in a vault on behalf of investors. The key word here is “account”: investors in grantor trusts are direct shareholders of the underlying assets rather than the fund that owns them. As a result, investors are taxed as if they directly owned the gold or the currency.