Taxes
For investors in taxable accounts the structure of the ETP can have a significant impact on total returns. Open-end ETFs and UIT ETFs have tax attributes very similar to conventional funds. Income distributions and dividends must be passed through to the investor each year, along with any realized short- and/or long-term capital gains. Both structures provide the benefit of in-kind redemptions, eliminating most of the capital gains, although there are still situations that may cause realization of capital gains, such as exceeding the diversification rule under the 1940 Act. Most ETNs, on the other hand, provide a little more tax efficiency than the other structures because the IRS views them as prepaid contracts, which are not subject to taxation until liquidation of the position. Most ETNs do not pay out any sort of interest payment or dividend distribution, which means there is no annual tax. When the investor sells the ETN or it matures, the standard short- and long-term capital gains rates apply. For currency ETNs, however, the IRS is not as liberal with its rulings. For currency ETNs all capital gains, regardless of the holding period, are treated as ordinary income and are taxed at the investor's highest marginal tax rate.
GTs and LPs each have unique tax issues. Vehicles structured as GTs generally deliver exposure to precious metals. Most if not all back their shares with holdings of physical bullion. As with their ETN counterparts GTs do not pay out any sort of interest payment or dividend distribution, which means there is no annual tax, and investors are taxed upon sale of the ETP; gains are subject to the collectibles rate of 28% for long-term gains. GTs that use futures contracts are taxed at the 60/40 hybrid rate cited below. The majority of LP ETPs use the futures market to gain their exposure. Investors are required to pay capital gains taxes on unrealized gains each year, regardless of sale. Each year 60% of the gains are taxed at the long-term rates, while the remaining 40% are taxed at the short-term rate (in 2012 that adds to 23%). Gains on swaps or options are not subject to the 60/40 rule. Because of the tax-inefficient nature of LPs, investors may want to hold LPs in a qualified plan [i.e., a 401(k) or IRA].
Expenses
Some ETP costs occur at the time of purchase, while other costs are ongoing. In particular, ETP investors need to focus on operating expenses, commissions, and bid/ask spreads. All funds assess some form of annual fee to cover management expenses and administrative fees, combined here as "operating expenses, which are most important to those investors who intend to hold the ETPs for a long period. Because ETPs are bought on the open market, commissions typically are assessed on both the purchase and the sale and need to be subjectively considered in the total cost review. Since the price of an ETP is determined by a market maker of the security, the bid/ask spread can be considerably different from one ETP to the next. An ETP's spread will vary based on liquidity, assets under management, and possibly the market demand for its underlying securities.
In our hypothetical example in Table 2, the total one-year cost of ownership is the sum of the expense ratio, bid/ask spread, and trading commissions. The difference in that cost between the two selected ETFs in Lipper's Utility Funds classification is staggering. Obviously, iShares MSCI ACWI ex-US Utilities Sector Index Fund (AXUT) will have to make up a lot of lost ground because of the total cost in order to be competitive against its peer, Select Sector Utilities Select Sector SPDR Fund (XLU). So, a side-by-side comparison can be very helpful during the purchase process.
Tom Roseen, is a senior analyst with Lipper. He is the editor and an author of Lipper's
U.S. Research Studies, Fundflows Insight Reports and Fund Industry Insight Reports.
