ETFs have become very popular with institutional investors over the past decade or so. Only in the past couple of years have ETFs started to become attractive investment options for retail investors as well. Part of the reason why more investors have yet to include ETFs in their portfolios is because they can be a bit confusing at first. ETFs were originally designed to track popular indexes like the NASDAQ 100 and deliver similar performance for investors. Unlike indexes, however, ETFs are traded on exchanges and their prices fluctuate throughout the day - in other words, they trade like stocks.
The major advantages that ETFs offer investors are diversification of investments and lowered risk, lower costs than mutual or index funds, flexibility because they trade like stocks, and tax advantages like the ability to defer capital gains. However, not all ETFs are created equal and there are actually four different types for investors to choose from:
Unit Investment Trusts, or UIT's, were the first of the ETFs and the big names for this type include: Spiders, Midcap
Spiders, Diamonds, and Cubes. All of these ETFs were created by the American Stock Exchange which continues to be the most popular exchange for ETFs. All of these ETFs were designed to track the major indexes like: S&P 500, S&P Midcap, Dow Jones Industrials, and the NASDAQ 100.
One of the issues with UIT's is that they hold all dividends received and then pay them out to shareholders on various distribution dates. When this happens, a tracking error is created because the value of the ETF is no longer in line with the underlying index due to the cash exposure caused by the payout. The tracking error is not a huge issue, but it does cause some headaches for accountants come tax time.
UIT's are not the most popular version of ETFs these days, but the Spider ETF is still the largest with assets in excess of 40 billion dollars.
The most common ETFs are produced using an open-end fund. These open-end funds are created according the rules set forth in the Investment Act of 1940. This basically just means that ETFs reinvest dividends automatically so there are no worries about tracking errors like with the UIT's.
ETFs of the open-end fund type track a number of indexes (the major ones as well as the less popular ones). Some of the open-end ETFs track specific market sectors as well. With the exception of the fact that dividends are reinvested automatically, open-end fund ETFs function and trade in the same manner as UIT's. Some of the more common ETFs from this type include: iShares, Streettracks, and Powershares.
Vanguard Index Participation Receipts, or VIPERS, are ETFs that were created by Vanguard. VIPERS are a very different kind of ETFs because they are actually a class of Vanguard index funds. This can create a problem because of the regulation that states "capital gains must be distributed across all share classes." Therefore, there is potential for exposure to capital gains when shareholders own other Vanguard mutual funds. Vanguard attempts to negate the capital gains by selling off losing investments through the creation/redemption process.
Holding Company Depository Receipts, or HOLDR's, are ETFs marketed by Merrill Lynch. These specialized ETFs are created as grantor trusts and offer a number of advantages over the other types.
HOLDR's are usually created using a basket of 20 related stocks. The baskets are all unified in theme and contain stocks from any number of highly specialized industries or sectors, including: B2B services, Internet architecture, biotech and any number of niche markets. Once the basket is complete, the stocks will not change for the life of the ETF unless there is a bankruptcy, merger, or some other factor causing the business to cease operations.
What is truly unique about HOLDR's is the fact that investors are considered to be owners of the underlying stocks in their basket. This means that investors are able to vote and receive dividends. In addition, an investor can "un-bundle" stock from their basket and make a non-taxable exchange (sell off bad investments and buy more good ones to offset potential capital gains). Of course there is a small fee for this un-bundling, but the tax savings are usually more than worth the charge.
The four different types of ETFs all offer varying degrees of investment performance and each comes with specific tax implications. The right ETF for any specific investor will depend upon their needs and investment objectives.