This page of our SIE Study Guide covers the investment products known as exchange-traded products (ETPs), which are often considered to be low-cost alternatives to mutual funds or other actively managed funds.
ETPs are bought and sold like individual stocks on an exchange. They track underlying securities, indices, or other financial instruments, and their prices are derived from these underlying instruments. Most ETPs are structured as UITs (See Packaged Products) or exchange-traded funds (ETFs) and can be passively-managed or actively-managed.
- The objective of passive ETPs is to replicate the benchmark performance of the financial instruments they track.
- Actively-managed ETPs are less common and do not seek to replicate a benchmark performance; rather, the fund manager selects specific investments to try and beat the market and outperform the benchmark.
Exchange-traded Funds (ETFs)
ETFs are packaged portfolios with a finite or limited number of available shares, which operate similarly to closed-end funds with minor technical differences. While they allow for portfolio diversification the same as mutual funds, they are different in that they come with real-time (intraday) pricing and require lower (sometimes zero) investment minimums and brokerage commissions. They are tradeable all day long on stock exchanges at bid and ask prices—the same way regular corporate stocks are traded each day—and they typically track an index.
- The term real-time pricing, also known as intraday pricing, means the price of an ETF can change frequently throughout the day like any other individual stock. Mutual funds, on the other hand, are always priced at the end of the trading day such that all sellers or buyers of the fund receive the same price.
- The total cost of owning an ETF is determined primarily by four direct costs and other varying indirect costs. Direct costs include expense ratio, brokerage commissions, premiums/discounts, and taxes. ETFs carry lower fees than mutual funds and are generally considered more liquid.
- There are many different types of ETFs with many different investment strategies. For example, a stock ETF will hold a portfolio of equities in a particular sector or index. If the portfolio contains dividend-paying equities then the fund will pay out annual (or occasionally more frequent) dividends. A bond ETF will invest in bonds and/or other fixed-income securities and pay out interest through monthly dividends. Real estate ETFs primarily invest in REITs and real estate operating companies but they might also own physical real estate.
- As a reminder, when investors trade ETFs on an exchange, they are buying or selling shares of the fund itself rather than its underlying assets or securities.
ETF Tax Treatment
Stock ETFs are considered more tax-efficient than mutual funds as most are passively managed through the tracking of an index and thus do not generally make frequent capital gain distributions (by selling off holdings). More specifically, as opposed to mutual funds, when an investor sells shares of an ETF the fund manager does not have to sell holdings in order to pay them as ETF shares are traded directly between investors on an exchange.
- Taxable events occur in stock ETFs when an investor personally sells their shares for a profit or is paid a dividend. In the first scenario the investor will have to pay a capital gains tax dependent upon how long the ETF was held and in the second scenario the investor will have to pay a tax dependent upon whether the dividend is qualified or unqualified. Qualified dividends—those held for a specified period of time known as the holding period—are taxed at lower capital gains rates whereas unqualified dividends are taxable as ordinary income.
Bond ETFs generally have the same tax treatment as stock ETFs with some exceptions. Like stock ETFs, when investors sell their shares of a bond ETF (for a profit) they are required to pay a capital gains tax dependent upon how long those shares were held. However, since bonds mature regularly, bond ETFs make capital gains distributions more frequently than stock ETFs.
Additionally, interest payments made by a corporate bond ETF are not considered qualified dividends by the IRS and are thus taxable as ordinary income. There are a few tax exemptions depending on the types of bonds held in the portfolio; for example, interest payments made by bond ETFs holding U.S. government bonds are generally exempt from state and local taxes.
Exchange-traded Notes (ETNs)
Exchange-traded notes are separate and distinct from ETFs and are also much less common. They are senior, unsecured debt obligations issued directly by a financial institution—such as a bank—that generally track a benchmark index and do not actually hold a portfolio of assets or securities. Instead, the issuer promises to pay the holder of the ETN, at maturity, a return based upon the underlying benchmark or index’s performance minus applicable fees. Maturity dates are typically 15 to 30 years from the original issuance date.
ETNs come with several different risks and are not suitable for every investor. Most notably, unlike regular debt instruments, ETNs do not make periodic interest payments nor do they promise to repay the principal amount invested. Instead, payments are linked to the underlying assets which means, depending on the performance of the underlying assets, these payments made at maturity can be higher or lower than the principal amount—sometimes significantly. Additional risks include but are not limited to credit risk of the issuer, market risk, and liquidity risk.
Investment Risk >>