The Inequality in Exchange-Traded Products

Over the last four years, there has been a widening market for global exchange-traded products (ETPs). In fact, according to the BlackRock Global ETP Landscape Report, it has grown from $598 billion in 2006 to $3.5 trillion in 2016.

As they grow, the waters might get muddy for the average investor, leading them to pick the first ETP that comes their way. Unbeknownst to most investors, each product reacts differently depending on the state of the market. Most ETPs are one of the following:

  • Exchange-Traded Funds (open-end funds or ETFs)
  • Unit Investment Trusts (UIT)
  • Grantor Trusts
  • Limited Partnerships (LPs)
  • Exchange-Traded Notes (ETNs)

Now that we’ve identified the most common ETPs, it’s time to dive into the pros and cons of each investment type and the effects they can have on an investor’s portfolio.

Types and Sub-Types

ETFs/Open-End Funds

Often referred to as open-end funds, ETFs pass all income, capital gains and losses, and dividends through to its shareholders. Dividends from these funds are usually reinvested until they’re distributed to investors on a quarterly or annual basis. Through their unique structure, they can use portfolio sampling, derivatives, and securities lending to increase returns to investors. In most cases, these products simply keep pace with the S&P 500, but some companies, like Pimco, have deployed more active strategies through ETFs.

Actively managed ETFs give investors similar exposure to mutual funds with intraday liquidity and minimal trading costs. To put it in context, mutual funds are only bought and sold at the end of the day after price fluctuations have been calculated.

UITs

UITs aren’t a far cry from open-end ETFs, barring a few minor differences. First, UITs are not permitted to loan securities, which is a common tactic used by fund managers to pump up returns. This limitation often means UITs copycat basic indices.

Secondly, this type of investment vehicle doesn’t reinvest dividends. Instead, they hold on until it’s time to pay investors. As a result, “dividend drag” comes into play, which means returns are not realized from dividend proceeds while they’re waiting to be disbursed. This can ultimately result in a reduction in returns relative to other investment structures.

Lastly, UITs feature termination dates that are established at the onset of the fund – these range from a few years to decades. In the case of equity UITs, they typically expire over 50 years from the start date. Alternatively, fixed-income UIT expiration corresponds with the maturity date of the bond investments held in the trust.

Grantor Trusts

These are investment options that typically hold futures and physical commodities. Taxation is treated as if an investor were holding onto the underlying security and a pro-rata share of income and trust expenses are taken out.

Trusts holding physical commodities have their gains taxed as regular income – in many cases at 28 percent. Trusts holding futures are taxed every year even if the position has been sold. In this scenario, 40 percent of the capital gains are taxed as short-term, while 60 percent are taxed as long-term.

LPs

LPs are very similar to grantor trusts in that they take a pro-rata share of the expenses and income of the partnership. All LP owners are sent a K1 form toward the end of the year for tax purposes. Just as with grantor trusts, futures held by the partnership yield taxes at the end of the year even if the position isn’t sold. Gains are taxed at the hybrid rate shared by grantor trusts – 40 percent at short-term capital gains and 60 percent at the long-term capital gains.

Unfortunately, transparency isn’t as strong with LPs when comparing them to open-end ETFs, grantor trusts, or UITs. If you’re looking for examples, look no further than United States Natural Gas (UNG) and United States Oil (USO).

ETNs

Exchange-traded notes have a completely different set of attributes with regards to the above. These vehicles produce no income distributions or dividends to speak of. Capital gains aren’t realized until the sale, maturity, or redemption of the ETNs, which means they may help with tax efficiency. They are typically unsecured, senior, unsubordinated debt securities that are meant to reflect returns linked to the performance of a market index, sans investor fees.

The reason for the lack of transparency in ETNs is related to the structure of the portfolio. There aren’t typically securities for investors to research or have any recourse with. With an ETN, investors hand over their cash to the issuer and receive compensation linked to an underlying index (less fees) identified in the prospectus. To ensure they get the best deal, investors are expected to analyze the credit quality of the issuer. If the credit quality of the issuer suffers, it could have a negative impact on the value of the ETN.

Investors can always opt into asset classes with complex tax characteristics by investing in an ETN that offers synthetic exposure to those assets. Some ETNs provide investors exposure to master limited partnerships without holding the underlying assets. In an effort to try to avoid creating a complex tax situation, these products seek to help investors replicate the returns in a portfolio.

Final Thoughts

ETPs have very subtle differences, but they all serve a very unique purpose. In attempting to maximize portfolio efficiency and avoid unwanted risk or exposure, it’s absolutely necessary for financial advisors to understand the difference before investing client money. Know what you’re selling.

Disclosure

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly.

Investing involves risks, including possible loss of principal. No strategy assures a profit or protects against loss.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Limited partnerships are subject to special risks, such as potential illiquidity, and may not be suitable for all investors.

Unit Investment Trusts (UITS) are a fixed portfolio of securities with a set term. Strategies are long term, therefore investors should consider their ability to pursue investing in successive trusts and the tax consequences.

An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Structured products typically have two components; a note and a derivative and a fixed maturity. They are complicated investments intended for a “buy and hold” strategy and offer protection from downside risk in exchange for forgoing some upside potential to achieve that protection. Principal protection may vary from partial to 100 percent.

Investing in structured notes is not equivalent to investing directly in the underlying securities or index and carry risks such as loss of principal and the possibility that you may own the referenced asset at a lower price, due to economic and market factors that my either offset or magnify each other. At maturity, if the derivative turns out to be valuable, the investor can gain exposure to the upside of that index.

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