What are the five ETF structures?

 

Each ETF structure has unique advantages and disadvantages, including tax implications. Understanding these differences can help you better satisfy the particular investment needs of your clients.

Today, there are five ETF structures. While all are subject to the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act), two are also regulated under the Investment Company Act of 1940 (1940 Act).

Among the questions to ask when considering ETFs for your clients is which legal structures—and the products that fall under their purview—best suit your clients' needs? Here are descriptions of each structure and some advantages and disadvantages of each.

Open-end funds | more

The vast majority of ETFs are structured as open-end funds, which is one of two types of ETF registered investment companies regulated under the 1940 Act. The open-end structure is generally used by ETFs 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, and derivatives, portfolio sampling, and securities lending can be utilized in the portfolio. Open-end ETFs that meet certain Internal Revenue Service standards are treated for tax purposes as pass-through entities (known as regulated investment companies), with income and capital gains distributed to shareholders and taxed at the shareholder level.

Advantages

  • Investors receive protections under the 1940 Act, as well as the 1933 and 1934 Acts.
  • Funds avoid cash drag through immediate reinvestment of dividends.
  • Funds can use derivatives, sample an index, and engage in securities lending.
  • Investors can access nearly any equity or fixed income sector or subsector.

Disadvantage

  • Funds have a limited ability to access alternative asset classes such as commodities or currencies.
Unit investment trusts (UITs) | more

A UIT is an investment company that holds a generally static investment portfolio and is used by a small number of ETFs that track broad asset classes. With no boards of directors or investment advisors managing the portfolio, UITs have less investment flexibility than open-end ETFs. For example, UITs do not reinvest dividends and instead hold them until they are paid to shareholders, usually quarterly. During rising markets, this can create a disadvantage known as cash drag.

In addition, UITs are not permitted to lend securities in the portfolios or use derivatives, and they must fully replicate the indexes they track. However, like an open-end fund, UITs are registered investment companies regulated under the 1940 Act and therefore offer the same level of investor protections as open-end funds. UIT ETFs that meet certain Internal Revenue Service standards are treated for tax purposes as pass-through entities (known as regulated investment companies), with income and capital gains distributed to shareholders and taxed at the shareholder level.

Advantages

  • Investors receive protections under the 1940 Act, as well as the 1933 and 1934 Acts.
  • A UIT is highly transparent because it fully replicates its underlying index.
  • A UIT has no investment manager to pay, which helps keep costs low.

Disadvantages

  • Since a UIT has no investment advisor, it is less flexible than open-end funds. (For example, it cannot use derivatives or lend securities.)
  • A UIT has a limited ability to access alternative asset classes such as commodities or currencies.
  • There is potential for higher tracking error due to cash drag.
Grantor trusts | more

Grantor trusts are typically used by ETFs that invest solely in physical commodities or currencies. Grantor trusts are required to hold a fixed portfolio, as opposed to a variable one, making the structure ideally suited for physical commodities and currencies.

Because the nature of the underlying investments prevents grantor trusts from being classified as investment companies under the 1940 Act, grantor trust ETFs are regulated only by the 1933 and 1934 Acts. Therefore, while grantor trust ETFs must disclose regular financial information, they provide none of the additional investor protections laid out in the 1940 Act. Grantor trust ETFs also do not qualify for regulation by the Commodity Futures Trading Commission (CFTC), unlike partnership ETFs (described below).

ETFs that use the grantor trust structure consider investors direct shareholders in the underlying basket of investments. As such, investors are taxed as if they directly owned the underlying assets.

Advantages

  • Grantor trust ETFs are highly transparent because of the simple, fixed nature of the portfolio.
  • They have the ability to invest in alternative investments such as commodities and currencies.

Disadvantages

  • They are not regulated by the 1940 Act or the CFTC.
Exchange-traded notes (ETNs) | more

ETNs are issued as prepaid forward contracts that, like a bond, contractually promise to pay a specified sum—in this case, the return of a given index (minus the issuer's expenses). ETNs are different from other ETF structures because they don't hold any underlying assets. Instead, they represent a promise by the issuer (usually a bank) to pay a return. Investors in ETNs become unsecured creditors of the issuing bank and therefore need to take into account an additional risk—credit risk—when they are considering the purchase of an ETN.

ETNs have a preset maturity date, and they usually do not pay out an annual coupon or dividend. They are also frequently created for niche markets, sectors, or strategies, including commodities, currencies, and certain emerging markets. Since ETNs are simply a promise to pay a specified return, tracking error is eliminated once costs are taken into account.

Keep in mind that ETNs are debt instruments, not investment companies. They are not regulated under the 1940 Act and lack many of the investor protections provided under that act's framework.

Under current tax law, ETNs typically 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, so investors typically don't incur taxes on them until the time of sale. However, it's important to know your client’s tax bracket and investment time horizon, especially in light of some of the uncertainties surrounding the future taxation of ETNs.

Advantages

  • ETNs provide access to niche markets that could be difficult to track with a traditional 1940 Act ETF structure.
  • Tracking error is eliminated after factoring in costs. There is the potential for favorable tax treatment.

Disadvantages

  • There is the potential for significant credit risk.
  • There is the potential for concentration risk since ETNs tend to invest in very narrow market segments.
  • Investors in ETNs receive no protections under the 1940 Act.
Partnerships | more

Among the least common types of ETFs, partnership ETFs are unincorporated business entities—such as a statutory trusts or limited partnerships—that elect to be taxed as a partnership. Partnership ETFs are considered publicly traded partnerships because they trade on a stock exchange. They generally are treated as partnerships for tax purposes, which avoids double taxation at both the entity and the investor level. The income and realized gains and losses from a partnership ETF flow through directly to investors, who then pay taxes on their share. However, depending on what they invest in, partnership ETFs could be taxed as corporations.

Partnership ETFs can accommodate many different types of investments, including futures that provide exposure to certain types of commodities that are hard to store physically. For example, while grantor trust ETFs can be used to invest in gold or silver (commodities that don't deteriorate over time and can be stored at relatively low cost), partnership ETFs generally track commodities such as natural gas and oil (which are difficult to store and lose their value over time). So instead of holding these items physically, partnership ETFs access these products through the futures market.

Partnership ETFs are usually regulated as commodity pools by the CFTC. While regulations by the CFTC include disclosure and reporting requirements, they are not as stringent as those required by the Securities and Exchange Commission under the 1940 Act.

Advantages

  • Partnership ETFs provide access to a broader range of investments beyond equities and fixed income.
  • Commodity-based futures ETFs are regulated by the CFTC and the National Futures Association and must comply with the Commodity Exchange Act.

Disadvantages

  • Investors in partnership ETFs must file a complicated Schedule K-1 tax form each year.
  • Investors in partnership ETFs receive no protections under the 1940 Act.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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