ETF Legal structure

Introduction

Exchange-traded funds (ETFs) are investment companies that list shares in the stock exchange [investment companies collect financial assets from investors, manage an investment portfolio, and issue shares to investors].

The legal structure of ETFs determines their scope of operations. Most ETFs are designed as an Open-end Investment Company (OEIC) or Unit Investment Trust (UIT) to invest in physical assets classified as ‘securities’, ‘equities’, or ‘bonds’ (open-end refers to a continuous offering of an unlimited number of redeemable shares to the public). These ETFs may qualify as regulated investment companies for U.S. Federal tax purposes. Synthetic ETFs are legally structured as Limited Partnerships (LP) or Grantor Trusts (GT) to invest in derivatives of physical assets. Synthetic ETFs don’t qualify as regulated investment companies.

ETFs that list shares in the United States (U.S.) must register with the U.S. Securities and Exchange Commission (SEC) in compliance with the Investment Company Acts of 1933 and 1940. The OEIC and UIT are registered under the Investment Company Act of 1940 and all preceding Acts. OEICs and UITs that are listed in the U.S. stock market must hold at least 80% of the underlying assets in securities relevant to the fund’s name. By comparison, the LP and GT are registered under the Investment Company Act of 1933 and all preceding Acts. What follows is a functional characterization of these structures under the broad headings of managed and unmanaged portfolios ^1,2.3,4,5.

Managed portfolios

The OEIC and LP operate managed portfolios under the governance of a board of directors. Both legal structures have these characteristics:

Managers may may choose to invest in derivatives, rebalance the portfolio, and lend underlying securities from the portfolio.
Shareholders don’t have voting rights to govern firms that issue assets owned by the ETF.

Most OEICs hire an independent investment advisor to invest in a sample of the fund’s strategic index. The portfolio dividends are reinvested or paid to shareholders on a monthly or quarterly basis ³. In LPs, the general partners typically manage a portfolio of stable assets in the energy sector ⁶, although other commodities, securities, and currencies are permissible investments. All partnership income is passed to the investors, who are called limited partners ^3,7.

Unmanaged portfolios

The UIT and GT operate fixed, unmanaged portfolios in compliance with a trust agreement. The investment portfolios are never rebalanced and the underlying securities are never lent out. UITs operate a portfolio of securities that replicate a market index. The portfolio dividends are not reinvested but instead held for quarterly or annual payment to shareholders. Shareholders are joint owners of the UIT and don’t have voting rights on the underlying securities. The UIT has an expiration date that is typically extended by the SEC ^3,8,9. GTs operate a portfolio of securities, commodities, or currencies. The shareholders are joint owners of the underlying assets and have voting rights on the underlying securities. GTs don’t generate income and must therefore pay expenses by selling assets. Shareholders are responsible for the tax consequences ^9,10.

Portfolio management error

Managers of OEICs and LPs may rebalance the fund’s portfolio in an attempt to improve fund performance. The general downside risk of portfolio mismanagement is that dilution of the net asset value diminishes the share price in the stock market in one of several ways. Firstly, rebalancing the portfolio increases the fund’s expenses. Secondly, the performance of the rebalanced portfolio may drift from the fund’s investment strategy. Thirdly, managers may seek to earn more fund income by lending securities to hedge funds and traders who wish to execute investment strategies such as ‘shorting ^11,12. The ETF portfolio benefits by splitting the lending fee with the lending agent. Some portfolios earn more than others for reasons that include¹³:

Conflict of interest: Portfolios typically receive less of the lending fee when the lending agent belongs to the same company that operates the Fund.
Asset liquidity: Less frequently traded small cap stocks earn higher lending fees than more frequently traded large cap stocks.

The lending of underlying assets for a fee may create failed trades in the primary market ^14,15. The practice of lending securities is described in the Fund’s schedule of investments and its Form N-Q filing with the SEC. Fourthly, management’s attempt to hedge the fund’s investments with derivatives (e.g., swaps, repos) may result in the acquisition of collateral assets that have low liquidity.

The legal structure of UITs and GTs does not permit management of the portfolio beyond the terms of the trust agreement, so there is less risk of management error. These trusts operate a portfolio of fixed composition that is not re-balanced at the discretion of the managers. Any trusts that receive dividends will make cash distributions to shareholders on a quarterly or annual basis. “Dividend drag” refers to the shareholder’s potential loss of income due to delayed receipt of the fund’s cash distribution.

Synthetic ETFs

“Synthetic” ETFs (e.g., LPs) use derivatives, not physical assets, to replicate a benchmark index. The LP can have investment and systemic risks that are hidden by the complexity of the fund’s operations and holdings. Systemic risk is the risk of collapse of an entire financial market. One of the systemic risks is “failed trades” ^{4,11,14,15,16}.

Benefits of the ETF legal structure

The ETF legal structure offers two major benefits to investors:

Diversification. Investors can diversify their investments by selecting fund portfolios according to market region (domestic, foreign) and asset class (securities, commodities, currencies, derivatives). ETFs that hold securities are considered ‘transparent’ by virtue of the online publication of the portfolio’s intraday net asset value and investment holdings.
Stock market listing. ETF shares are traded by public auction in the stock market during trading hours. Traders can devise a number of trading strategies by placing a limit order, stop order, or accepting the current market price ⁴.

References

1. Investment companies. U.S. Securities and Exchange Commission, 3/29/2010. http://www.sec.gov/answers/mfinvco.htm

2. Investment company registration and regulation package. U.S. Securities and Exchange Commission, 4/2/2009, modified 3/2/2012. http://www.sec.gov/divisions/investment/invcoreg121504.htm

4. BIS Working Papers No 343: Market structures and systemic risks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011. http://www.bis.org/publ/work343.pdf

5. Little, Pat. Is that an ETF? Research Note, Hammond Associates, September, 2010.

6. Investing Workbook Series: Stocks 3. How to Refine Your Stock Strategy. Morningstar, 2005.

7. Legal structure. http://admainnew.morningstar.com/directhelp/Glossary/Operations/HF/Legal_Structure.htm

8. Unit Investment Trusts (UITs). U.S. Securities and Exchange Commission, 5/8/2007, http://www.sec.gov/answers/uit.htm

9. http://www.investopedia.com

11. Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist. http://www.economist.com/node/18864254

12. Ari L. Weinberg. Exchange Traded Funds: When ETFs are Lenders. Wall Street Journal, July 6, 2011. http://online.wsj.com/article/SB10001424052702303823104576391573704929238.html?KEYWORDS=when+etfs+are+lenders

13. Zweig, Jason. When Funds lend stock, who gains? The Wall Street Journal, October 22, 2011. http://online.wsj.com/article_email/SB10001424052970203752604576645442999588006-lMyQjAxMTAxMDMwMDEzNDAyWj.html?mod=wsj_share_email

14. Harold Bradley, Robert Fawles, Robert E. Litan, and Fred Sommers. Canaries in the Coal Mine. How the Rise in Settlement “Fails” Creates Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation. http://www.kauffman.org/uploadedfiles/canaries-in-the-coal-mine-report.pdf

15. Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs). Financial Stability Board, 12 April 2011. http://www.financialstabilityboard.org/publications/r_110412b.pdf

16. Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist. http://www.economist.com/node/18867037?story_id=18867037

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