The market for global exchange-traded products (ETPs) has experienced tremendous growth in the last decade, growing tenfold from $145.7 billion in 2002 to $1.641 trillion in 2012 (Blackrock ETP Landscape Global Handbook 2012).

Although the average investor may think that all ETPs are created equal, the way these products are structured can differ greatly and they can act very differently depending on the market. The most common structures for ETPs are exchange-traded funds (open-end funds or ETFs), unit investment trusts (UIT), grantor trusts, exchange-traded notes (ETNs), and limited partnerships (LPs). Before investing in an ETP, it is critical to understand the pros and cons of each structure and what effects they can have on an investor’s unique situation.

Structure Types And Sub-types
ETFs are considered open-end funds in which dividends, income and capital gains/losses pass through to shareholders. Dividends from ETFs are typically reinvested until distributed to investors, usually on a quarterly or annually basis. This structure is the most flexible, allowing the use of derivatives, portfolio sampling and securities lending. While the majority of products in this category passively track an index such as the S&P 500, companies like Pimco have recently debuted active strategies under this structure.

Active strategies in ETF form provide investors exposure comparable to that of a mutual fund with both lower trading costs and intraday liquidity (normal mutual funds are only bought/sold at the end of the day after all price fluctuations have been calculated).

UITs share many of the same characteristics as open-end ETFs, with a few subtle differences. First, UITs are not allowed to loan securities, a tactic used by fund managers to enhance returns. Due to this restriction, UITs tend to replicate basic indices.

Additionally, UITs do not reinvest dividends and instead must hold them until they are paid out to investors. This feature often results in a phenomenon known as “dividend drag,” which is the return foregone by not having those dividend proceeds invested while awaiting disbursement and can reduce the potential returns to investors relative to the other structures.

Finally, UITs have termination dates that are established when they are created, and can range from a few years to decades. The termination dates for equity UITs are normally greater than 50 years (PowerShares QQQ terminates March 4, 2124, according to the prospectus), but fixed-income UITs typically set a termination date that corresponds with the maturity date of the bond investments held in the trust. Examples of UITs are SPDR S&P 500 (SPY), PowerShares QQQ (QQQ) and SPDR Dow Jones Industrial Average (DIA), which can be some of the cheapest and most tax-efficient investment vehicles available. 

Grantor trusts are vehicles that typically hold physical commodities (SPDR Gold Shares – GLD and iShares Silver Trust – SLV) and futures (PowerShares DB Commodity Index Tracking – DBC). They are taxed in the same manner as if an investor were to hold the underlying security and take a pro-rata share of the income and expenses of the trust.

If the trust holds a physical commodity, the gains are taxed as ordinary income, typically at a 28 percent rate. If the trust holds futures, the investor is taxed each year regardless of whether the position is sold. In this case, 60 percent of the capital gains are taxed as long-term and 40 percent are taxed as short-term to the investor.

Similar to grantor trusts, limited partnerships are a type of structure in which each investor takes a pro-rata share of the income and expenses of the partnership. Owners of LPs are sent a K1 form at the end of each year for tax purposes. As with grantor trusts, if the partnership holds futures than the investor is taxed each year even if the position is not sold, with gains being taxed at the same hybrid rate -- 60 percent at the long-term capital gains and 40 percent at short-term capital gains.

The transparency in LPs is limited in comparison to UITs, grantor trusts and open-end ETFs. Two examples of products utilizing this structure are United States Oil (USO) and United States Natural Gas (UNG).

The final vehicle, known as the exchange-traded note (ETN), is quite different than the previous four and has some unique features making it a viable option in certain circumstances. First, there are no dividends or income distributions for ETNs. Additionally, unlike the other vehicles, capital gains are only realized upon the sale, redemption or maturity of the ETN, making these products extremely tax efficient. Furthermore, ETNs are generally senior, unsecured, unsubordinated debt securities designed to reflect returns that are linked to the performance of a market index, less investor fees.

Typically, there is not an underlying portfolio of securities that investors have recourse or transparency with. Investors are essentially lending the issuer money and are not compensated with coupon payments, but with returns linked to an underlying index (less management/issuer fees) stated in the prospectus. These features require the investors to analyze the underlying credit quality of the issuer, an expertise that may fall outside the skillset of the average investor. It also means that deterioration of the credit quality of the issuer could negatively impact the value of the ETN.

For investors who wish to gain exposure to an asset class with complex tax characteristics, they may invest in an ETN that provides synthetic exposure to that asset. For example, the Credit Suisse MLP Index ETN (MLPN) is designed to provide exposure to master limited partnerships without actually holding the underlying assets, allowing an investor to replicate the returns in a portfolio without the added complexity when filing taxes each year.

The structures of these exchange-traded products differ slightly and are even regulated by different regulatory acts. ETFs and UITs are regulated by the Investment Company Act of 1940, but grantor trusts, limited partnerships and ETNs are regulated by the Securities Act of 1933. By understanding the full menu of ETPs and their nuances, one can maximize portfolio efficiency and avoid unwanted risk or exposure.

Aaron Gilman is chief investment officer at Independent Financial Partners, a registered investment advisory firm based in Tampa.