When your ETF isn’t an ETF

Exchanged Traded Funds have boomed in the past few years as investors piled in to the low-cost investments typically designed to follow a specific index or sector. ETFs offer many benefits – improved liquidity, very low cost, inherent tax-efficient structures and broad access to various asset classes. (If you are unfamiliar with ETFs, there is a decent primer here). According to the Investment Company Institute, the ETF market in the United States grew by 27.6% in 2012, an increase of over $288 billion. Below is growth in all exchanged-traded products over the past decade.

via The Reformed Broker
via The Reformed Broker

Riding on the coattails of a desire for more liquid, low cost and transparent investments are a number of products masquerading as ETFs. These might include Exchange-Traded Notes (ETNs) or other Exchange-Traded Products (ETPs) that are not actually “funds” – that is, they are not registered and held to the standards of the Investment Company Act of 1940. Many of these alternative structures sacrifice the original benefits of ETFs – specifically when it comes to costs and taxes.

Most commonly, these alternative products are found by investors and advisors looking to add  commodities to an investment portfolio. Directly investing in commodities is complicated – you either choose to buy and hold the physical commodity (manageable with gold bars, more difficult with barrels of oil) or participate in the commodities futures markets. Futures markets allow participants to hedge and speculate on the future prices of physical commodities, and oversight for these markets falls under the purview of the Commodity Futures Trading Commission, or CFTC, a federal government division.

The CFTC does not allows for futures investors to pool in a mutual fund.  Pooled commodity futures investments must be structured as Limited Partnerships, which complicates the tax structure and significantly reduces the tax efficiency of these products.  Investors who own commodity limited partnership ETPs will receive a K-1 and a split of long-term and short-term treatment of any pass-through income. Owning a limited partnership in a retirement account such as an IRA can trigger UBTI taxes.

Other commodity ETPs are structured as trusts which physically hold the commodity – this is most common with precious metal ETPs.  Again the tax treatment is complicated as the IRS considers these investments “collectibles” that do not qualify for long-term capital gain treatment. Here investors avoid the complication of the futures markets, but add the carrying costs and risks of the fund owning and storing significant quantities of physical commodities.

The final most common alternative structure for an ETP is an Exchange Traded Note.  As the name implies, these investments are actually bonds issued by a bank or financial institution.  Rather than pay a stated interest rate, they promise to track the performance of a certain index (up or down!).  In addition to the regular risks of investing, ETNs are subject to credit default and repayment is only as safe as the issuing bank.  So, you wouldn’t want to invest in an ETN from, say, Lehman Brothers.

These types of complications can also arise if investors use ETPs to gain access to currency markets, financial futures or other non-traditional assets.  For a deep dive on the tax treatment of ETPs, IndexUniverse has a great piece.


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