Ferri: Exchange-Traded Confusion

It's worth reminding investors that not all ETFs are created equal.

Reviewed by: Richard Ferri
Edited by: Richard Ferri

It's worth reminding investors that not all ETFs are created equal.

I’m sitting in my favorite coffee shop, drinking a nonfat latte and not minding my own business. A small group at a nearby table is seriously discussing the markets and investing. I naturally eavesdrop. One fellow was boasting about an exchange-traded fund (ETF) that has made him a ton of money. He went on and on about knowing this ETF was going to be a winner. That’s when I chimed in …

Excuse me. I couldn’t help overhearing. May I ask about that ETF?

Sure. Go ahead!

What type of structure is it?

Ah … I don’t know; what do you mean?

Well, there are different ETF structures, like open-end funds, UITs, grantor trusts, limited partnerships, exchange-traded notes. Do you know what type it is?

Not really. Does it matter?

It might … for taxes ... and depending on if it’s a physical or a synthetic.

I don’t know. All I do know is that it went up and I made money!

Got it! Sorry to have interrupted your conversation. Have a great day! [and exit].

As I walked away, their conversation turned to sports. Yeah, I’m a jerk, but I’ll bet the others at the table appreciated getting off the subject.

Exchange-traded funds and all the products related to them have terminology that’s foreign to many investors. People hear “ETF” and they assume every product that’s called an ETF is the same. They’re not. Product structure can have big implications for investors, especially if it’s held in a taxable account.

There are five basic exchange-traded product (ETP) structures: open-end funds, unit investment trusts (UITs), grantor trusts, limited partnershipss and exchange-traded notes.

Open-End Fund: All mutual funds are registered investment companies and are primarily regulated under the Investment Company Act of 1940 and the rules and registration forms adopted under that act. Investment companies are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. More than two-thirds of ETPs are structured as open-end funds. These are true-blue ETFs. Their open-end structure is generally used by companies whose primary objective is to provide exposure to stock and bond asset classes.

Dividends and interest received by an open-end ETF can be immediately reinvested as they come into the fund. Derivatives can also be used in the portfolio. Open-end ETFs that meet certain Internal Revenue Service (IRS) standards are treated for tax purposes as pass-through entities, with income and capital gains distributed to shareholders and taxed at the shareholder level.


Unit Investment Trust (UIT): The second type of ETF that’s regulated under the Investment Company Act of 1940 is one that is structured as a UIT, although it is not technically a mutual fund. While only a few ETPs use this structure, they are some of the biggest. SPDR S&P 500 (SPY), SPDR S&P 400 (MDY), PowerShares QQQ Trust (QQQ) and SPDR Dow Jones Industrial Average (DIA) are UITs.

A UIT is unmanaged pool of assets that is inflexible. The securities in a UIT must replicate exactly the index they track. Unlike an open-end fund, no board of directors or investment manager exists to make subjective decisions about the portfolio. Like open-end funds, UITs that meet certain IRS standards are treated for tax purposes as pass-through entities with income and capital gains distributed to shareholders and taxed at the shareholder level.

Grantor Trusts: Grantor trusts are used to invest in “physical” commodities or currencies. They do not hold derivatives. SPDR Gold Trust (GLD), which holds gold bullion, and CurrencyShares Euro Trust (FXE), which holds actual euros, are good examples.

Because the underlying investments of Grantor trusts prevent them from being treated as mutual funds or UITs, it is not governed by the Investment Company Act of 1940. They are regulated under the Securities Act of 1933 and the Securities Exchange Act of 1934. These two acts cover the issuance of individual securities and how those securities trade on an exchange. Grantor trusts consider investors direct shareholders in the underlying investment. Thus, investors are taxed as if they directly owned the underlying asset.

Limited Partnership: These ETPs are unincorporated business entities that elect to be taxed as a partnership and receive a K1. The benefit is that they avoid double taxation at both the entity and the investor level. Partnership ETPs are usually regulated as commodity pools by the CFTC.

Like open-end funds, limited partnerships can accommodate many different types of investments, including futures and swaps. This is helpful in creating “synthetic” exposure to a market, which provides investors with indirect access to commodities that are hard to store physically; for example, partnership ETPs that track natural gas and oil using futures contracts such as The United States Oil Fund (USO).

Exchange-Traded Notes (ETN): ETNs are debt security that has a contractual obligation to pay a specified return at maturity. In most cases, this amount is the return of a given index or market, less expenses. ETNs typically don’t hold assets. Investors become unsecured creditors of the issuing entity. This creates credit risk in addition to market risk. ETNs are popular for niche markets, sectors or strategies, such as emerging markets, currencies and commodity strategies.

Like bonds, ETNs have a preset maturity date. Unlike bonds, they typically don’t pay interest. Most ETNs enjoy favorable tax treatment as prepaid forward contracts. Any accrued interest or dividends, and any appreciation in the value of the index, are generally rolled into the value of the ETN. Taxes are paid when you sell units of the ETN. ETNs are a promise to pay; they are not regulated under the Investment Company Act and lack many of the investor protections provided under its framework.


The definitions above are in no way complete and should not be relied upon for tax advice. There are several exceptions to the rules. Consult your tax advisor if you have specific questions.

I used the term "exchange-traded product (ETP)" several times rather than referring to everything as an ETF. An exchange-traded “fund” is a specific type of product structure that doesn’t technically fit all other structures. It could be argued that all ETFs are ETPs, but not all ETPs are ETFs. There are mixed feelings on this issue in the investment community.

Dave Nadig, chief investment officer at ETF.com, prefers to call everything an ETF. That may be a somewhat biased view given his company’s name, but Nadig makes sound points: “In our editorial world, we’ve adopted ‘ETF’ as the ‘Kleenex’ brand for the product structure encompassing Investment Company Act of 1940 registered mutual funds, UITs, Grantor Trusts, Commodities Pools and Exchange Traded Notes.” Nadig admits this isn’t perfect: “Technically, probably only the Act [Investment Company Act of 1940] funds should be considered [an ETF].”

Vanguard agrees with this view. In Vanguard’s investor education guide ETF Structures at a Glance, every product structure is called an ETF. The guide doesn’t mention exchange-traded products or use the ETP acronym.

Charles Schwab takes the opposite view. In their Overview of Exchange Traded Product (ETP) Structures brochure, Schwab writes, “While most investors are familiar with the term ETF, several other investment products are also exchange-traded and are therefore similarly categorized… Because ETFs represent the vast majority of these exchange traded investment products, the term is often used as a catchall. It’s more accurate, however, to use the term ‘exchange traded product’ (ETP) as the umbrella under which ETFs and other related investment products fall.”

Deborah Fuhr splits the products into two mutually exclusive types, ETFs and ETPs. Fuhr is the managing partner of ETFGI, a research and consulting firm, and probably the most widely respected analyst in the industry. In her view, ETFs include only open-end funds and UITs, while every other structure is an ETP. “Exchange-traded products (ETPs) are products that have similarities to ETFs in the way they trade and settle but do not use an open-end fund [Investment Company Act of 1940] structure.”

Personally, I called everything an ETP in The ETF Book, then separated products into different categories: ETFs, UITs, LPs, grantor trusts and ETNs. So, why isn’t my book title "The ETP Book"? For the same reason ETF.com calls everything an ETF and Fuhr’s company is named ETFGI rather than ETPGI—few people would recognize our brands otherwise. As Nadig puts it, “I think that battle is lost.”


Richard Ferri, CFA, is founder and managing partner of Portfolio Solutions. He directs the firm's research and education, and is head of the Investment Committee. Ferri writes regularly for the Wall Street Journal, Forbes, the Journal of Financial Planning and his own blog at www.RickFerri.com.