7 types of ETF structures
There are many inherent advantages to exchange-traded funds (ETFs), and many of them depend on the type of legal structure involved. Financial advisers need to understand these types of legal structures to determine how ETFs can be of use to their clients’ portfolios.
The tax-advantaged nature of ETFs makes them a great alternative to mutual funds. However, the tax implications for ETFs will also vary depending on their legal structure.
Seven types of ETF structures:
- Open funds
- Mutual fund
- Grantor trusts
- Exchange Traded Notes
- C companies
- Managed exchange traded funds
1. Open funds
The majority of ETFs are structured as open funds, which fall under the regulatory measures of the Investment Companies Act of 1940. These types of ETFs generally provide investors with exposure to the most common assets, namely stocks and the obligations.
However, open-ended funds have limited access to other asset classes like commodities, so diversity is limited. However, income from dividends and interest can be immediately reinvested in an ETF.
From a tax liability perspective, income and capital gains can flow directly to shareholders if the open-ended fund meets Internal Revenue Service standards as a flow-through entity. This avoids the aspect of double taxation of a company.
2. Unit Investment Trusts (UIT)
According to Investopedia, an open-ended investment trust is “an investment company which offers a fixed portfolio, generally made up of stocks and bonds, as units redeemable to investors during a specified period”. ITUs are used by ETFs to track broad asset classes and unlike open funds, their investment capacity is limited.
In addition, ITUs do not reinvest dividends. Instead, they are held until it is time to pay the shareholders of the fund.
However, from a tax point of view, ITUs are treated as open-ended funds in the sense that they have passed-on taxation. Since there is no board or investment manager in ITUs, this also makes them less expensive instead of less investment flexibility.
3. Grantor’s trust
ETFs structured as transferor 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 are more subject to regulatory measures than an open-ended fund. In particular, they must meet the requirements set by the Investment Companies Act of 1933 and 1934.
For this reason, ETFs structured as a grantor trust must provide additional financial information.
From a tax standpoint, ETFs structured as cedant trusts consider investors to be direct shareholders of the investments held in the fund. Investors are therefore taxed directly.
4. Exchange Traded Notes (ETN)
ETFs structured like ETNs are prepaid futures contracts that promise to pay out a specified amount equal to the return made from an index. As such, ETNs do not contain any actual assets.
Individuals who invest in ETNs are subject to additional credit risk as they essentially become unsecured creditors of that ETN and do not enjoy any regulatory protection under the Investment Companies Act 1940. Therefore , no asset can be sold to repay creditors since ETNs trump them.
Very similar to a bond, an ETN has a maturity date on which investors receive the returns, if any, of the index. ETNs are typically used to satisfy investors looking for exposure to niche markets such as currencies, commodities, and international assets.