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Exchange-Traded Products and Taxes

Don't be caught off guard by taxation of nontraditional ETPs.

Abraham Bailin, 02/02/2011

Fueled by increasing popularity, the exchange-traded product space continues to grow at a staggering pace. More often than not, the discussion of ETPs generally pertains to their advantages and disadvantages relative to the traditional open-end mutual funds, and while comparison is certainly warranted in this regard, it may be all too easy for investors to lump all exchange-traded products into one category while doing so. Here, we outline a number of ETP structures and discuss the tax implications of each.

Before we begin, let me note that I am not a registered tax advisor. Each investor will have a unique set of tax circumstances to which I am not able to speak. Please consult your accountant to verify your tax status for this and all investment products.

The Traditional ETF & the ETN
As the number of exchange-traded fund offerings grows, so, too, does the number of funds that provide exposure to any given slice of the market. One of the first distinctions that investors make within the space is between funds that hold their index constituents and those that do not.

An exchange-traded note, is an unsecured debt obligation from a backing bank. The vehicle can be viewed as a promissory note and looks to deliver the precise return of its underlying index. ETNs do not hold any of their index constituents; rather, the notes merely track their return. For this reason, ETNs afford investors exceptionally low tracking error. The primary exception to this rule, of course, is the deduction of a management fee. The primary danger associated with the ETN is that it exposes investors to the credit risk of the backing bank.

Unlike ETNs, traditional ETFs do in fact hold a basket of securities. SPDR S&P 500 SPY, for example, holds the 500 underlying equity securities of its S&P 500 Index. Because full replication (matching the index exactly) can be unwieldy at times, most funds allow themselves the use of a conservative replication strategy. Funds using this strategy devote less than 100% of total assets to holdings stipulated by the index. They use remaining assets to attempt to match index returns by holding instruments with significantly similar performance. Sampling can lead to tracking error. On the other hand, ETFs are not exposed to the credit risk of a single backing bank as ETNs are.

Investors should understand that an ETF is a look-through vehicle. Holding an ETF, investors can generally expect to pay taxes as if they directly owned the fund's underlying holdings. At most times, absent erratic market activity, a traditional ETF and a mutual fund of the same type should garner similar tax treatment. During times of net redemptions, however, the ETF structure has proved to be generally more tax-efficient. A key advantage over the mutual fund structure is that, in most cases, ETF investors are only taxed for their own investment activities. In contrast, open-end mutual fund investors may be liable for taxable events that took place even before they established the position.PAGEBREAK

Tax treatment for these ETN and traditional ETF structures is similar in that investors are required to realize capital gains/losses upon liquidation of the position. Liquidation after a one-year holding period subjects investors to long-term capital gains taxes at rates no greater than 15%. Liquidation before one year passes subjects investors to short-term capital gains taxes at ordinary income rates.

Tax treatment between the two structures does, however, differ markedly with regard to distributions. An ETN is technically a debt security, and as such, its distributions are taxed at ordinary income rates, like any taxable bond. That said, distributions here are not common.

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