The Changing Complexity of Exchange-Traded Funds

As exchange-traded products (ETPs, which include ETFs, ETNs, ETCs, and the like) have proliferated in the marketplace, the once-simple product has become much more complex and is perhaps even a trap for unsuspecting investors. ETPs, therefore, warrant a brief review and discussion of a plan of action for helping clients identify the right ETP. Since 1993 when the first U.S. ETF was brought to market, assets and the number of offerings have grown exponentially. The few offerings of the mid- to late-90s have blossomed to over 1,473 issues with a total value as of September 2012 of $1.3 trillion.

Figure 1 Growth in ETPs by Number of Funds (Structure) and Assets Under Management ($Bil)

Source: Lipper. Note: ETF depository receipts were shuttered as of January 9, 2012.

The strategic and tactical benefits of ETPs versus their conventional mutual fund counterparts include: low cost, transparency, tax efficiency, flexibility (short and margin positions), and intraday trading. However, the complexities among ETP offerings have increased, and investors should understand how these issues impact their total-return experience. The structure of an ETP can impact its risk-reward trade-off, costs, and tax-efficiency nature. For example, an ETP tracking the same index but structured as an open-end fund or a unit investment trust (UIT) might have completely different return series and tax-efficiency characteristics than one structured as a limited partnership (LP) or grantor trust (GT).

Of the ETP structures shown in Table 1, the most popular are open-end funds and UITs, often referred to as 1940-Act funds. Because of diversification limitations and other regulatory issues governing those structures, investment firms launched other products registered under the Securities Act of 1933 to use other legal structures to meet the demand for access to asset classes beyond just fixed income and equities, including currencies, commodities, and short and leverage positions. These legal structures are governed differently than their 40-Act brethren, with the primary differences between the five main ETP structures centering on how portfolios are constructed, when and if distributions are reinvested, how taxes are assessed, and expenses.

Portfolio Construction

At the simplest level an ETP’s objective is to track the performance of an index of equities, fixed-income securities, commodities, or currencies as closely as possible; however, how each ETP structure achieves that goal can be drastically different. The primary asset management consideration is whether an ETP fully replicates or optimizes its benchmark’s constituents. ETPs that track indices with highly liquid securities often choose to fully replicate the benchmark by holding each constituent in the exact weighting of the index in order to minimize tracking differences. The S&P 500 Index is an example of a benchmark that is often fully replicated, and any tracking difference is attributed to the ETP’s operating expenses. SPDR S&P 500 ETF Trust (SPY) is an example of a UIT ETF that uses full replication.

Other ETPs track indices whose components are more difficult or costly to trade. The lack of liquidity, narrow market focus, large number of holdings, and high transaction costs are reasons for optimizing a portfolio rather than fully replicating it. These funds invest in a limited number of the benchmark’s securities by using an optimizing sampling technique to represent the performance characteristics of the index. While optimization can decrease a fund’s transaction costs, it can also increase the tracking difference.

Exchange-traded notes (ETNs) are a special ETP structure in which the fund doesn’t own any of the underlying securities of the benchmark but instead is a senior unsecured debt obligation of a bank that is linked to the exact performance of the market index less investor fees. For this reason ETNs provide investors low tracking differences. However, because ETNs don’t buy and hold assets to replicate or approximate the underlying index, they introduce counterparty risk/credit risk into the equation. With other ETPs, if an issuer has solvency problems, the underlying securities are available to the investor. However, with ETNs the investor could end up standing in line with the firm’s other general creditors. If the issuer defaults on the note, investors may lose some or all of their money. With the ongoing credit crisis in Europe, it would be smart for ETN investors in this post-Lehman Brothers environment  to keep an eye on the issuer’s credit rating offered by Moody’s, Fitch, or a similar rating agency. A perhaps more practical solution to real-time ratings that was put forth by the folks at Index Universe is to keep an eye on the issuing firm’s credit default swap (CDS) rates. A historical look at the one-year CDS rates for all ETN issuers could be quite telling.

In recent months we witnessed some troubles with ETNs that are worth mentioning here. In late March 2012 two ETNs, one issued by Barclays and another issued by Credit Suisse, experienced huge price movements up and then down after the financial issuers of the notes changed their willingness to engage in market-making for the ETNs in question. This led to a supply-and-demand issue that impacted the price of the ETNs, even though the underlying index had not changed significantly. In a resulting Financial Industry Regulatory Authority (FINRA) investor alert it was proposed that before trading in the secondary market, investors should compare an ETN’s closing and intraday indicative values (IIV) with the market price. If the ETN is trading at a significant premium to its closing value or IIV, investors should consider another product. They should ask if the issuer has suspended the note, and if so why.

Table 1 Exchange-Traded Product Structures—Comparative Matrix

Sources: NASDAQ and Charles Schwab

Taxes

As can be seen in Table 1, for investors in taxable accounts the structure of the ETP can have a significant impact on total returns. Open-end ETFs and UIT ETFs, being pass-through entities, have tax attributes very similar to conventional funds. Income distributions and dividends must be passed through to the investor each year, along with any realized short- and/or long-term capital gains. Both structures provide the benefit of in-kind redemptions, eliminating most of the capital gains, although there are still situations that may cause realization of capital gains, such as exceeding the diversification rule under the 1940 Act. Most ETNs, on the other hand, provide a little more tax efficiency than the other structures because the IRS views them as prepaid contracts, which are not subject to taxation until liquidation of the position. Most ETNs do not pay out any sort of interest payment or dividend distribution, which means there is no annual tax. When the investor sells the ETN or it matures, the standard short- and long-term capital gains rates apply. For currency ETNs, however, the IRS is not as liberal with its rulings. For currency ETNs all capital gains, regardless of the holding period, are treated as ordinary income and are taxed at the investor’s highest marginal tax rate.

GTs and LPs each have unique tax issues. Vehicles structured as GTs generally deliver exposure to precious metals. Most if not all back their shares with holdings of physical bullion. As with their ETN counterparts GTs do not pay out any sort of interest payment or dividend distribution, which means there is no annual tax, and investors are taxed upon sale of the ETP; gains are subject to the collectibles rate of 28% for long-term gains. GTs that use futures contracts are taxed at the 60/40 hybrid rate cited below. The majority of LP ETPs use the futures market to gain their exposure. Instead of receiving Form 1099, investors receive a Schedule K-1 tax filing. Investors are required to pay capital gains taxes on unrealized gains each year, regardless of sale. Each year 60% of the gains are taxed at the long-term rates, while the remaining 40% are taxed at the short-term rate (in 2012 that adds to 23%). Gains on swaps or options are not subject to the 60/40 rule. Because of the tax-inefficient nature of LPs, investors may want to hold LPs in a qualified plan [i.e., a 401(k) or IRA]. Obviously, understanding the tax implications for each of the ETP structures is vital to a client’s wealth-building experience.

Expenses

Because of the drag on returns, it is important for investors to understand and account for expenses when they evaluate ETPs. Some ETP costs occur at the time of purchase, while other costs are ongoing. The importance of the related expenses is a function of the size of the investment and the investment period. In particular, ETP investors need to focus on operating expenses, commissions, and bid/ask spreads.

All funds assess some form of annual fee to cover management expenses and administrative fees (combined here as “operating expenses”). Operating expenses are most important to those investors who intend to hold the ETPs for a long period. Because ETPs are bought on the open market, commissions typically are assessed on both the purchase and the sale and need to be subjectively considered in the total cost review. In addition, because the price of an ETP is determined by a market maker of the security, the bid/ask spread—the difference between what the market maker is selling the shares for (the “ask” or “offer” price) and buying at another price (slightly lower, the “bid”)—can be considerably different from one ETP to the next. An ETP’s spread will vary based on liquidity of the ETP, assets under management, and possibly the market demand for its underlying securities. Spreads should be incorporated into ETF trading decisions. They are perhaps most impactful to short-term traders but should be used in the overall total cost review for even long-term investors.

Table 2 Hypothetical Cost of a $10,000 Trade

Source: Eikon

In our hypothetical example in Table 2 the total one-year cost of ownership is the sum of the expense ratio, bid/ask spread, and trading commissions. The difference in the total one-year cost between the two selected ETFs in Lipper’s Utility Funds classification is staggering. Obviously, iShares MSCI ACWI ex-US Utilities Sector Index Fund (AXUT) will have to make up a lot of lost ground because of the total cost in order to be competitive against its peer, Select Sector Utilities Select Sector SPDR Fund (XLU). A side-by-side comparison can be very helpful during the purchase process.

Although most ETPs are structured similarly, it’s vital that investors and their advocates understand the differences between the various structures. In particular, portfolio construction can have a significant impact on the tracking difference of a fund versus its benchmark. In addition, the structure of the fund can predetermine the tax efficiency of the ETP versus similar products. Evaluating the impact of tax drag, expense drag, and portfolio construction can help an investor better evaluate and select the appropriate ETP for inclusion in a portfolio.

* This article originally appeared in the December issue of On Wall Street Magazine