| ETF Legal Structures | Open End Fund | Unit Investment Trust | Grantor Trust | Exchange-Traded Notes | Partnerships |
| Products | iShares, Select Sector SPDRs, PowerShares, Vanguard, and WisdomTree | BLDRs, Diamonds, SPDRs, and PowerShares QQQ Trust | Currency Shares, streetTRACKS Gold Shares, iShares Silver Trust, and Merrill Lynch HOLDRs | Barclays Global iPath, ELEMENTS ETNs | U.S. Oil Fund |
| Reinvests Dividends | Yes | No | No | Varies | Varies |
| Replication of Index | May optimize index | Must fully replicate index | Custom weighted basket | Varies | N/A |
| Registered Under | Investment Company Act of 1940 | Investment Company Act of 1940 | Securities Act of 1933 | Securities Act of 1933 | Securities Act of 1933 |
| U.S. Tax Reporting Method* | Form 1099 | Form 1099 | Grantor Trust Letter | N/A | Form K-1 |
*Tax reporting methodology listed is general. Consult your tax advisor
History of Exchange Traded Funds (ETFs)
In 1992, the American Stock Exchange (Amex) made use of the Securities and Exchange Commission's (SEC) "SuperTrust Order" to request use of the first authorized stand-alone index based exchange-traded fund (ETF). That petition was approved by the SEC and it paved the way for the release of the S&P Depository Receipts Trust Series 1, or "SDPRs". In time, they quickly gained acceptance in the marketplace and became the first commercially successful ETF.
The first U.S. listed ETF was the SPDRs (SPY) which launched on the Amex in 1993. The fund is benchmarked to the Standard & Poors' 500 Index. Later on, ETFs based upon widely followed benchmarks like the NASDAQ-100 (QQQQ), Dow Jones Industrial Average (DIA) and others would follow.
Key Legal Structures of ETFs
Traditional bond and equity ETFs are generally organized as open-end funds or unit investment trusts (UITs).
Investment products that track commodities, currencies, or other specialized strategies are typically registered as grantor trusts, exchange-traded notes, or partnerships. Although some of these structures share similar characteristics to traditional ETFs, they are not necessarily registered or taxed the same.
As the ETF universe evolves, the variety of product structures will likely follow suit.
All exchange traded funds follow three important legal structures. Below is a brief summarization of each.
Open-end index fund
The majority of ETFs follow the open-end structure because it allows the greatest flexibility. Dividends in these types of funds are immediately reinvested and paid to shareholders on a monthly or quarterly basis. This ETF design is also permitted to use derivatives, portfolio optimization, and lend securities. Open-end funds are registered under the Investment Company Act of 1940. ETF families that have this legal structure include iShares, Select Sector SPDRs, PowerShares, Vanguard, and WisdomTree.
Unit Investment Trust
The oldest and best known ETFs - including the BLDRs, Diamonds, SPDRs, and PowerShares QQQ Trust - are organized as UITs. This type of legal structure does not reinvest dividends in the fund, but instead holds dividends until they're paid to shareholders quarterly or annually. These mechanics cause a situation known as "dividend drag." UITs must fully replicate the indexes they track and receiving income from loaned securities is not permitted. Unlike open-end funds, UITs have expiration dates which can range from a period of years to decades. Most expirations are continuously rolled or extended. UITs are registered under the Investment Company Act of 1940.
Grantor Trust
This type of legal structure distributes dividends directly to shareholders and allows them to retain their voting rights on the underlying securities within the trust. The original securities in a grantor trust remain fixed and aren't rebalanced. Grantor trusts are registered under the Securities Act of 1933. The streetTRACKS Gold Shares, iShares Silver Trust, Merrill Lynch's HOLDRs and CurrencyShares follow this format.
Exchange-traded Notes (ETNs)
ETNs are registered as debt instruments that pay a return linked to the performance of a single security or index. The operating structure of ETNs is particularly suited for specialized asset classes such as commodities, currencies, and emerging markets. Since ETNs are not required to distribute income they are particularly tax-efficient for assets that pay ordinary income or short term capital gains. Under the current tax law, ETNs are treated and taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption, or maturity of their note. ETNs are registered under the Securities Act of 1933.
Partnerships
Some index linked products that resemble ETFs are actually operated as master limited partnerships (MLPs). Unit holders are required to report their share of the MLP's income, gains, losses and deductions on their federal income tax returns even if cash distributions are not made.
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