Posted on 03/04/2011
The Exchange Traded Fund Product world currently has over one trillion in assets according to the National Stock Exchange (www.nsx.com). Almost 90% of the assets are in Exchange Traded Funds (ETFs) and the remaining 10% is in Exchange Traded Notes (ETNs). Today we wanted to discuss the difference between an ETF and an ETN.
What is an ETF?
What is an ETN?
|An Exchange Traded Fund (ETF) is a basket of securities that are traded much like individual stocks. ETFs are listed on an exchange and constructed to track an index of some kind by investing specifically in the securities constituting that index. The first US ETF, for instance, was launched in 1993 to track the S&P 500 Index. The S&P SPDRs [SPY] "tracked" the index by owning the same 500 stocks in the same weightings as the index. When an investor purchased one share of SPY, they actually owned a portion of 500 securities. The "basket" structure is similar to traditional mutual funds, but the active intra-day trading of ETFs is much more like stocks. As well, the manner in which ETFs are created and redeemed allows them to typically trade very close to "NAV". Transparency has been a major selling point of ETFs, as current holdings are posted on a daily basis, allowing investors to see all securities held within a fund instantaneously.||Exchange Traded Notes (ETNs) are "unsecured promissory notes," essentially an obligation that is issued by a bank or other financial institution that is backed, generally, by the full faith and credit of that institution. In this sense, an ETN is structured much more like a bond than an ETF, except that the promissory note in this case is structured to track an index of some kind. ETNs have been issued that guarantee investors the return on a specific commodity index, exchange rate, and foreign equity markets. Each ETN has a stated maturity date much like a bond, but like a stock or ETF they can be bought and sold on an exchange at any point prior to maturity. ETN's can also be created and redeemed in a fashion similar to ETFs, which allows them generally to behave very differently than closed-end products that regularly stray far from "NAV". Unlike ETFs, an ETN carries the credit risk associated with the financial institution that issued the note, and this is the primary structural difference.|
Those are the basics of ETFs and ETNs, and during the typical trading session for the typical fund there is very little recognizable difference between the two. However, it is now the "typical trading session" that often causes problems, and so some of the nuances that differentiate these two products are worth discussing. Today we want to take a look at the K-1 difference which is particularly relevant to the ETF vs. ETN discussion.
A K-1 is typically used by some form of Partnership or S-Corporation to report a partner or shareholder's distributed share of income. In those cases the corporation does not pay an income tax, so the partners would receive a K-1 that represents their taxable income to be filed with their personal tax returns. The standard grudge with K-1s is that they are not typically available as early as other relevant tax records, many a K-1 has been blamed for extension requests to the IRS. After all, information for the corporate entity must first be gathered before accurate information can be distributed through a K-1. Hedge funds, limited partnerships, and many commodity-based ETFs function in this manner.
Many commodity (and some currency) funds provide their returns by holding a combination of US T-Bills and various commodity futures contracts, the PowerShares DB Family of Commodity ETFs offers an example of this. The funds are technically structured as limited partnerships, and though they don't "pass through" capital gains in the old-fashioned sense, they are still technically classified in this manner. As a result, the IRS requires funds that are structured as LP's to be "marked to market" at the end of each tax year. At this time investors are apportioned their share of gains or losses (i.e. Schedule K-1), which are taxed as 60% long-term/40% short-term gains. It's certainly not bad to receive K-1's, in fact, last year PowerShares made K-1s available on their website in late-February, and mailed them to investors in the first week of March. We are told they were made available even earlier this year, and furthermore PowerShares provides a tool to download Schedule K-1 information directly into Turbotax for any investors that may employ that software to file tax returns. For more information regarding tax information for PowerShares Commodity Funds visit: www.taxpackagesupport.com/dbfunds
For instance, the PowerShares DB Base Metals Fund (JJM) is a vehicle to invest equally in Aluminum, Copper and Zinc. However, DBB is a Base Metals ETF, using commodity futures contracts to create its exposure to those aforementioned metals. The result: an investment in DBB will generate a K-1 tax document. Meanwhile, the iPath DJ-AIG Industrial Metals Total Return ETN (JJM) is an alternative to DBB, and in fact is one of the four positions currently held in our iPath Commodity Model portfolio. JJM is an exchange traded note (ETN), which is to say that rather than buying a fund that holds futures contracts, you are instead buying a promissory note that is backed by the full faith and credit of the underwriter. Because it is the futures contacts that specifically trigger the K-1 in the case of DBB, using JJM as an alternative will side-step that issue. Of course, you then take on the credit risk of the issuer of the ETN, another important consideration.
Let it be known that we are not CPAs, we are not tax hobbyists, nor do we play one on TV. We have had numerous conversations with various ETF providers and have read enough information over the years to feel confident that the information we have provided is accurate (to the best of our knowledge), but again, we aren't CPAs and have no plans to pursue such an acronym anytime soon. In general the rule of thumb is this: if you buy a fund that invests in futures contracts you are going to generate a K-1 for your clients. The PowerShares Gold Fund (DGL) invests in Gold Futures contracts and thus will generate a K-1, meanwhile the iShares COMEX Gold Fund (IAU) invests in Gold Bullion (bars, bricks, etc) and does not generate a K-1 (though long-term capital gains are taxed at a higher "collectible" rate). It is likely that many of you have other investments that complicate tax returns enough such that one more K-1 is not a major issue so long as it is available in a timely fashion. If you would like to avoid a K-1 there are other options, Exchange Traded Notes (ETNs) being one of them, but naturally come with their own separate set of considerations.