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Is an ETF Really a Fund? Maybe Not
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By Dow Jones

Question: An exchange-traded fund can also be . . .

A. A conventional mutual fund
B. A trust
C. A limited partnership
D. Any of the above

Answer: The answer is D . . . and that means potential complications.

Investors typically think of ETFs as a distinct type of security, but they're all built on a structure that can vary from fund to fund. In most cases, the chassis is the familiar "open end" mutual fund. But exchange-traded products can take a number of other forms -- from limited partnerships to debt issues. And each of them has implications for taxes, liquidity, tracking error and credit risk.

Here's what you should know about some of the varieties:

Unit Investment Trusts

Some of the oldest ETFs were created as UITs — the only structure that regulators would allow at the time. These vehicles are treated like standard mutual funds under federal rules, but there are special features that set them apart from other ETFs.

For one thing, they have an expiration date. Consider SPDR S&P 500 -- the first and still the largest ETF. The trust, often known by its ticker symbol, SPY, is set to close in 2118, 125 years after its 1993 launch. (There are contingencies that may keep it around a bit longer, though.)

Another feature of UITs has a bigger short-term impact: Unlike a conventional fund, a UIT can't reinvest dividend income from stock holdings. SPY, for instance, pays out its accumulated cash once a quarter.

For buy-and-hold indexers, this "cash drag" can slightly diminish SPY's performance relative to the Standard & Poor's 500-stock index on the way up but enhance it on the way down, since a portion of money in the fund isn't going up or down with the market.

You should also know that some UITs have overwhelming trading volume — which makes them easy to buy and sell, and their prices stick closely to the values of the underlying securities. SPY is the most heavily traded ETF, and another UIT-based offering, PowerShares QQQ Trust, which tracks the Nasdaq-100 Index, is third.

That activity is due in part to options traders, says Scott Burns, head of ETF research at Morningstar Inc. The trusts offer the traders several advantages, including a better tax setup than other index options, says Keith Goggin of Integral Derivatives.

Grantor Trusts

These vehicles aren't funds; they're trusts that issue exchange-traded shares. Instead of investing in securities or engaging in active management, they hold an asset and pass along ownership stakes to investors.

For instance, SPDR Gold Trust, or GLD, has gold bullion that is primarily held in a London bank vault, and passes direct claim of ownership to individual stock holders. When U.S. investors sell their stake in GLD at a gain, they are subject to the 28% tax that applies to collectibles and precious metals, not the lower capital-gains taxes on conventional fund holdings.

GLD, recently the second-largest exchange-traded product, is the most prominent example of a grantor trust. Rydex's CurrencyShares series and Merrill Lynch's HOLDRs franchise also took the grantor-trust path.

Limited Partnerships

ETFs that get exposure to the commodities markets by buying futures contracts are often structured as investment partnerships. These partnerships are treated by regulators as commodity pools -- groups of investors who buy commodities — that invest in futures. Like trusts, they aren't technically investment companies, and they pass through all income, gains, losses and deductions to shareholders.

ETFs structured this way include several from United States Commodity Funds LLC and some commodity funds from PowerShares and ProShares.

One potential drawback of holding a partnership-based ETF is the tax reporting: Investors get a less-familiar Schedule K-1 instead of the 1099s that are supplied by most other funds and ETFs. That can mean more complexity at tax time.

For funds held in taxable accounts, there can be more expenses. Tax treatment depends on the ETF's underlying holdings, but consider what happens to a partnership that holds futures. Gains in futures get taxed every year, whether or not the holder sells them. With broad index funds, investors can delay most or all of the tax hit until they decide to sell their shares.

Another issue: Gains on futures are split 60/40 between long-term and short-term capital gains, while an investor might choose to hold a traditional index fund for more than a year to have the full gain subject to the lower long-term gains rate.

Added Share Classes

Vanguard Group has patented its approach to ETF structure: offering exchange-traded shares along with conventional shares in a single fund. The company says there's an advantage in adding an ETF share class to an existing index fund or launching a fund with both share types: reduced capital-gains distributions for ETF shareholders and holders of other share classes.

For instance, while individual investors sell ETF shares only on exchanges, some institutions can redeem large ETF holdings by giving the sponsor the ETF shares and receiving an equal value of underlying securities. Vanguard says this setup benefits all of a fund's holders, since the company can opt to deliver the shares that have gone up the most since purchase; if the fund had to sell those shares, it would incur capital-gains taxes.

Others in the industry say the Vanguard structure doesn't serve investors better than other ETFs do. Noel Archard, managing director for BlackRock Inc.'s North American iShares, says the single-share structure most companies use provides tax efficiency and simplicity.

Exchange-Traded Notes

Exchange-traded notes are sometimes lumped in with ETFs, but there's a big difference between them: ETNs are actually debt issues of the sponsor, typically a bank.

Here's how these vehicles work. Banks issue ETNs as unsecured corporate debt, promising returns linked to a benchmark, often in hard-to-obtain areas, like certain international markets or more complex derivatives shut off to retail investors. The banks hedge their risk via futures contracts or swap agreements with other large institutions.

One advantage that ETNs have is little tracking error; by contrast, when ETFs hold a portfolio of securities, the ETF returns sometimes vary quite a bit from the return on the benchmark index.

Another difference: Gains and losses for ETNs are treated as capital transactions, unlike the tax treatment for futures and physical-commodity-based funds. Thus, ETNs have grown for strategies including commodities and currencies.

While ETNs continue to grow, the failure of three small Lehman Brothers ETNs in 2008 remains a black eye.

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© Dow Jones. All rights reserved.

This material is authored by Dow Jones and was not authored by Merrill Lynch. Assumptions, opinions and estimates constitute judgment from Dow Jones as of the date of this material and are subject to change without notice. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that shares, when redeemed or sold, may be worth more or less than their original cost.

Please note that ETFs are registered investment companies that have prospectuses containing detailed information about the fund, including expenses and risks. Some ETFs may also have product descriptions, which summarize key information about the ETF and explain how to obtain a prospectus. You should carefully consider the investment objectives, risks, charges, and expenses before investing in this product. This and other important information is included in the prospectus, which should be read carefully before investing.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

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