If exchange-traded funds were merely a less expensive, more tax-efficient way to invest in stocks and bonds, they would be worthy of all the praise bestowed upon them. But they are so much more. Instead of merely creating a new asset class, the ETF structure opened up many asset classes to a new and easier way of investing. It's had the dual effect of bringing in investors who would never have ventured here in the past, as well as increasing the liquidity of the underlying markets.
Strictly speaking these new ETF-like products aren’t funds at all. As registered investment companies, Itrue ETFs can only hold securities. They’re restricted from holding more than a very small amount of commodities or other kinds of assets. These new offerings are exchange-traded products (ETPs) and many actually hold commodities and futures contracts. These ETF-like products have different structures than ETFs, which means they may be taxed differently than funds that hold stocks or bonds.
This article will examine the major exchange-traded products (ETPs) on the market. It will explain the differences between these exchange-traded vehicles and more traditional ETFs. Typically, the tax implications for an exchange-traded commodity product and an exchange-traded currency product are dramatically different from an ETF—and sometimes even from each other. Many don't have the tax efficiency for which ETFs are known. Regardless, they make investing in commodities and currencies much cheaper and much easier to grasp.
Exchange-Traded Notes (ETNs)
Exchange-traded notes (ETN) don't actually hold assets, but are unsecured debt purchased from an investment bank. As such, they have completely different characteristics from the other products. They offer better tax efficiency and less tracking error than true ETFs. However, in addition to regular market risk, they come with credit risk from the issuing bank.
Invented by Barclays Bank in 2006, ETNs were created to make it easier for retail investors to invest in hard-to-access asset classes. Barclays Global Investors, a former subsidiary of Barclays Bank, ran iShares, the largest family of ETFs. (Barclays sold BGI to Blackrock in 2009.) To differentiate the products, the ETNs received the family name iPaths. BGI released commodity products under the iShares brand, but anything that doesn't contain equities or bonds misses out on some of the tax advantages of ETFs—especially commodities and currency. And stocks in emerging markets have high spreads and aren't necessarily liquid enough to be purchased in large amounts.
Barclays created the ETN to make it easier to invest in and maximize the returns of those hard-to-access instruments. It did this by eliminating the costs associated with holding commodities, currencies and futures and revving up the tax structure to make it potentially the most tax efficient product in the exchange-traded product industry.
Like ETFs, ETNs trade on a stock exchange. Some track a single asset, but most track a benchmark index. If the index falls in value, so does the ETN. But that's where the similarities end. Funny thing though, the ETNs don't really own what they track. ETNs don't hold stock, bonds, or even futures contracts.
Unlike ETFs, ETNS are senior, unsecured debt issued by an investment bank. The principle isn't protected and there is no collateral backing it. ETNs are similar to prepaid forwardcontracts. According to the Tax Adviser (a publication of the American Institute of Certified Public Accountants) a prepaid forward contract is a structured investment instrument in which an entity, in this case the ETN issuer, sells shares to the investor for upfront cash payment. The ETN provider transfers to the investor a significant portion of its risk of loss and opportunity for gain. Investment banks have long offered structured instruments and notes like prepaid forward contracts to institutional clients.
The key difference between the ETF and ETN is that the ETN doesn't actually own anything. An ETF holds assets with real value. Each ETF's portfolio holds underlying shares of companies which will be worth whatever the stocks are worth on the day that the ETF's shares are redeemed. Also, the ETF could be liquidated by selling all the underlying shares, ending up with cash.
ETN investors don't own shares of a portfolio of stock. It's essentially a bet on the index's direction guaranteed by an investment bank. The bank promises to pay at maturity the full value of the index, minus the management fee. That means investors might not get paid if the issuer goes belly up. This exposes the investor to credit risk.
ETNs are not only much more tax efficient than the ETPs that hold commodities, they’re better than ETFs as well. Unlike ETFs, the iPath ETNs make no distributions of dividends or income. This is a very big deal. Even regular ETFs can distribute quarterly dividends on which taxes need to be paid annually, and which can be charged as ordinary income.
Because ETNs don’t hold any portfolio securities there are no distributions to make to their investors during the 30-year lifetime. However, the ETNs promise to pay the total return of the index it tracks. Total return of an index, which is considered the most accurate measure of actual performance, assumes that all dividends and distributions are reinvested in the index. Because the value of the ETN’s shares is the total return of the index, the value of the dividends has been incorporated in the index’s return.
Because “dividends” are “reinvested” in the ETN, the shareholder doesn’t pay taxes until he sells the shares. At that point they are taxed as long-term capital gains at a rate of 15 percent for the entire investment.
This ability to significantly boost returns by escaping annual taxes on dividends is a close to magic as one gets on Wall Street. The one downside is that while the ETF investor gets to spend the dividends immediately, the ETN investor has to wait until he sells his shares.
For ETNs that track currencies, the Internal Revenue Service made a ruling the concluded that ETNs that track foreign currencies must be considered debt for federal tax purposes. This completely eliminated the favorable tax treatment. Like other currency investments, currency ETNs are now taxed as ordinary income. While it looks like it levels the playing field it actually puts the ETNs at a disadvantage. Because the ETNs don’t hold currencies, they don’t generate income. But much in the way that dividend distributions increase the index’s total return, this implied currency interest is considered to be reinvested to boost the value of the currency ETNs. The IRS ruled that even though ETN shareholders didn’t receive the income as a distribution, they still need to pay taxes on the implied “phantom” income. So, in an opposite situation, from the dividends, holders of currency ETNs are paying taxes now on income they won’t receive until they sell their shares at a later date.
The first U.S.-listed commodity-based ETP was streetTracks Gold Shares, now named the SPDR Gold Shares (symbol: GLD). Sponsored by the World Gold Council and marketed by State Street Global Advisors (the trustee for the SPDR), it launched November 18, 2004, on the New York Stock Exchange. Each share represents one-tenth of an ounce of gold bullion as priced by the London Bullion Market Association (LBMA), the British gold industry's trade association. Like an ETF, the objective of the ETP is to capture the return of underlying assets, but instead of holding stocks or bonds, it holds hundreds of tons of real gold bricks.
It's hard to compare a stock fund to a commodity vehicle because the assets don't operate the same way. For instance, gold needs to be stored somewhere. This isn't an issue for stocks and bonds. While shareholders in the gold shares don't need to worry about it, much like any other purchaser of gold, managers of ETPs that hold physical assets need to pay fees to store and insure the gold. This can get expensive and the fund may sell off gold to pay expenses.
ETPs that hold physical assets are not registered under the Investment Company Act of 1940 or the Commodity Exchange Act (CEA). Thus, the gold ETPs are neither investment companies nor commodity pools that hold and trade futures contracts. Shareholders don't get the protections associated with either act.
Many ETPs that tracks precious metals back the value of the shares by holding the physical assets in a vault. All the ETPs that hold physical assets are structured as grantor trusts, a nontaxable entity that corporations use to issue asset-backed securities.
Grantor trusts register their shares for public sales under the U.S. Securities Act of 1933, also known as the 1933 Act, or the “truth in securities” law. This is the first law to regulate the securities industry of the stock market crash of 1929.
The grantor trust concept is interesting because ownership of the underlying investment held by the trust passes through directly to the investor. In ETFs and mutual funds, shareholders don’t own the stocks, but rather a pro-rata share of the entire portfolio. The grantor trust gathers and holds assets, but the shareholder actually owns a proportionate share of the underlying assets relative to the number of shares owned.
The difference between a fund and a grantor trust is analogous to the difference in apartment ownership. In a condominium, the person owns the actual apartment and can do with it as he pleases. In a co-operative apartment building, an investor doesn’t actually own an apartment, but rather owns shares in the co-op that are represented as an apartment. In this case, the grantor trusts are the condominiums, while mutual funds and ETFs are like co-ops.
Shareholders will be taxed as if they own the underlying gold, just like a gold coin. Under current law, gains on gold bullion held for more than one year are taxed like the sale of "collectibles," at a maximum rate of 28 percent, rather than the 15 percent rate applicable to most other long-term capital gains.
In addition to the commodity ETPs that hold physical assets, some commodity ETPs track the price of a commodity through futures contracts. Because they don’t hold physical assets, but derivatives, they can’t be structured as grantor trusts. Instead, they are structured as a limited partnership called a commodity pool. The commodity pool gathers money from many investors to invest in a portfolio, usually comprised of futures contracts. Because commodity pools trade commodity futures, they need to register with the National Futures Association and agree to be regulated by the Commodity Futures Trading Commission, or CFTC. In addition, because the ETP sells a security traded on an exchange, and issued in a public offering, it also registers its shares under the 1933 Act and is regulated by the SEC.
Unlike stocks, futures are not transferable. The owner of a futures contract can’t assign it to another investor. So, the commodity pool’s creation unit is not an in-kind trade like in the ETF. The Authorized Participants pay cash to the commodity pool for the value of the ETP’s shares. Unlike the ETF, the commodity pool ETP must go into the market and buy its own futures contracts. This adds a commission, or transaction cost, not found in the traditional ETF.
Futures also generate a lot of taxes. Because futures need to be closed before they expire, the fund incurs a capital gain or loss depending on how the market moved. In addition, the pool is required to “mark-to-market” the contracts open at the end of the year. This means all open contracts will be treated as if they were sold on the last day of the year, even if they weren't.
All commodity gains in the fund are taxed the same as regular futures contracts. No matter how long the assets were held, these yearly capital gains are taxed as if 60 percent were long-term gains, currently a tax rate of 15 percent, and 40 percent were short-term gains, taxed as much as 35 percent. Because it’s structured as a limited partnership any capital losses inside the ETP may be used by the investor to offset his personal capital gains. This is a big advantage over a mutual fund, which keeps the capital losses inside the fund to cut internal capital gains. Partnerships report taxes on a complicated and lengthy form known as a K-1 schedule. You should seek an accountant’s advice on how to handle this.
Trading foreign currencies is simply exchanging one country’s currency for another. Currencies are bought on the spot market, called the Foreign Exchange or Forex market, or with futures contracts. It’s the largest market in the world. Currency ETPs come in two varieties: the kind that hold the actual foreign currency and those that track currencies through futures contracts. Again, the tax structures are different from ETFs and must be examined before buying the shares.
Unlike gold and silver, which incur costs for storage and insurance, financial institutions will pay you to let them hold your money. So, the currency ETPs hold their currency in interest-bearing accounts with a custodian. The depositary credits an overnight rate to the portfolio, which is distributed monthly in the form of income.
Like the precious metal shares, the currency shares that hold the actual currency are grantor trusts. These ETPs give currency exposure to a single currency and allow the shareholder to participate in the movement of that currency relative to the dollar. Like the gold and silver shares, the grantor trust is a pass-through vehicle. Therefore, the shareholders are treated as if they own the foreign currency directly. There is no in-kind process to pull taxes out of the trust. Because of this, the currency shares do not get the favorable tax treatment bestowed upon stocks and bonds. All the capital gains and interest distributions from the currency trusts are taxed as ordinary income.
As for the ETPs that use futures to track a currency, these are also held in commodity pools. The same tax rules that apply to the commodity ETPs – 60 percent long-term capital gains/40 percent short-term capital gains – apply here.
In the end, when picking an ETP, in addition to the asset's risk, investors need to consider the tax issues and which exchanged-traded product structure best suits their needs.
Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.
Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors which may include changes in national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, and global or regional political, regulatory, economic or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.