Exchange Traded Portfolios (ETPs) Part 2: Structural differences among ETPs

In part one of this article, we reviewed Exchange Traded Portfolios (ETPs) and defined them as including Exchange Traded Funds (ETFs) and Notes (ETNs). They trade like common stock but create mutual fund-like exposures. Part 2 will examine the different structures under which ETFs are created, and the key distinction of ETNs.

There are several major structures used in the creation of an ETP, and new ones are on the horizon. We’ll focus on those aspects which may be relevant to compliance.

Unit Investment Trust (UIT) ETF structure is regulated under the Investment Advisers Act of 1940 (“’40 Act”) but is not open ended, although the term may last decades. Because UITs are nonmanaged pools of assets, managers must own all the securities in the fund’s target index. There are concentration restrictions and a prohibition on reinvestment of dividends. Dividends must be held pending periodic distribution, creating the phenomenon of ‘drag’, particularly when the index securities have appreciated.

Regulated Investment Company (RIC), ’40 Act open ended funds, are the most common ETF structures. While the objective of a RIC ETF is still to track its target index, managers may deviate from those securities, a tactic often known as ‘sampling’. Also unlike the UIT structure, dividends may be reinvested. Non-diversified funds are permitted, with concentrations up to 50%. Securities lending, which is typically fully collateralized, is allowed.  A Board of Directors is voted in by the Authorized Participants (APs).

Exchange Traded Grantor Trust ETF structure is regulated under the Securities Act of 1933. Like the UIT structure, this is a nonmanaged pool whose portfolio is fixed, which may lead to over- and underweight positions. The grantor trust structure does provide significant shareholder voting rights which the UIT structure lacks. Another difference is that dividends are paid out immediately to shareholders.

Registered Investment Trust ETF structure is also regulated under the Securities Act of 1933, which facilitates their use for a commodity-focus. Typically, multiple parties are associated with this structure. For example, the SPDR Gold Trust (GLD) lists a trustee, custodian, sponsor and marketing agent, some or all of which may factor into party exposure limit calculations. This is in addition to the APs, who perform their typical creation and redemption function. No in-kind redemptions are permitted, and investors have no voting privileges.

Exchange Traded Notes (ETN): Although traded on exchanges, ETNs are not ETFs. ETNs are unsecured debt of the issuing bank. However they pay no interest. Returns are based on the performance of a benchmark, after fees, until a stated maturity date. As such, they have little to no tracking error. Investors have no claim on the ETN’s assets because the issuer has no obligation to acquire any of the assets represented by the benchmark. Simply put, the bank owes ETN holders the index returns and nothing else. If the bank itself fares badly (but remains solvent) and the index shoots skyward, the ETN is obligated to deliver that index return. If the bank does not remain solvent, the performance of the index becomes a fairly moot point. Finally, as notes, ETNs have no need for Authorized Participants.

Know your limits: ETFs and ETNs—which are Investment Company Securities—are governed by 12(d)1 of the ’40 Act. Subsequently the SEC has granted non-U.S. funds some relief to these limits as well as limited exemptive relief to the 3% ownership limit.  The daily holdings disclosures should also be of interest, as such exposure may augment or offset outright positions held by the asset manager. Disclosed are the specific securities, quantities held, and cash positions.

Regardless of the structure used in the creation of an Exchanged Traded Portfolio, as with mutual fund holdings, looking through to the ETP components will increase the accuracy of compliance checks.

In Part 3, we’ll compare multiple ways to achieve exposure to gold, and discuss some of the resulting compliance ramifications.