When most analysts and investors refer to the ETF industry, they frequently use the term to apply to all exchange-traded products that are traded like stocks. In reality, the landscape is not quite that simple, and the term "ETF" is used a bit too liberally. ETFs must receive an order from the SEC that gives it relief from the Investment Company Act of 1940, a piece of legislation that was designed to instill investors' confidence in mutual funds and protect the public interest. The provisions of this act don't allow for the ETF structure, so potential issuers are required to acquire exemptive relief before moving forward with a fund launch.
Included in our comprehensive database of exchange-traded products are a number of securities that don't meet the strict requirements of an ETF; these "ETF cousins" may look, feel, and trade like exchange-traded funds, but are actually members of a different breed of investment securities. Some of these distinguishing characteristics are relatively minor in nature, while others can potentially have a material impact on the risk/return profile of a security:
Exchange-Traded Notes (ETNs)
Exchange-traded notes offer investors exposure to a variety of asset classes, ranging from sugar [iPath DJ-AIG Sugar (NYSE: SGG ) ] to Indian equities [iPath MSCI India Index (NYSE: INP ) ]. But an investment in an ETN is actually an investment in a senior unsecured debt security issued by a financial institution. Unlike most debt instruments, these notes don't pay a fixed rate of interest or floating rate based on LIBOR or some other benchmark. Instead, these returns (often including coupon payments) are based on the performance of an underlying index [see ETNs: The Good And The Bad].
There are some pros and cons to ETNs. Tracking error is essentially eliminated, since there is no basket of underlying holdings to be managed; rather the return is calculated based on movements of a hypothetical index. The cons all relate to credit risk; because an ETN is debt, it's subject to the creditworthiness of the issuer. If the issuing bank goes under, investors can be left holding the bag.
Some investors are quick to write off the credit risk associated with ETNs. While most of the institutions issuing these securities (Barclays (NYSE: BCS ) , UBS (NYSE: UBS ) , etc.) are on solid financial footing, relatively recent history includes some cautionary tales. Lehman Brothers was an ETN issuer before the company went belly up; investors in these securities got in line with the rest of the creditors after the firm failed [see Basics Of ETN Investing].
Holdings Company Depository Receipts (HOLDRS)
The products from Merrill Lynch are often included under the ETF umbrella, but are in reality a different animal. The HOLDRS are publicly traded grantor trusts; investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940. There are a number of differences between HOLDRS and ETFs, including voting rights (owners of HOLDRS can vote for the underlying securities), "round lot rules," and a unique expense structure [see Five Facts About HOLDRS Every Investor Should Know].
As far as most investors are concerned, the most important element of HOLDRS is the manner in which they rebalance holdings. In most cases, they don't; the securities held in the initial basket are still held today. If a company is sold or delisted, there is no reshuffling of components to bring another stock into the basket. That's why the B2B Internet HOLDRS (Amex: BHH) has only two holdings; nearly all of the original holdings have been either sold acquired or gone bankrupt [see The Curious Case Of The B2B Internet HOLDRS].
Exchange-Traded Commodity Products
Some of the most popular ETPs on the market offer exposure to natural resource prices through a strategy that calls for physically buying and storing the underlying commodity. [SPDR Gold Shares (NYSE: GLD)], the $50 billion fund whose holdings consist of gold bullion, is perhaps the best example of this strategy.
GLD (and other physically backed exchange-traded commodity products) is in many ways similar to traditional stock and bond ETFs. The level of diversification, however, is noticeably absent; the gold ETF has just one underlying holding (gold bullion).
Many commodity products aren't registered as an investment company under the 1940 act, meaning that shareholders don't have the protections provided by that piece of legislation. That generally won't have a significant impact on the investing experience, although it's worth understanding the ramifications of this slightly different structure [also see Beware The New "Silver ETF"].
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Disclosure: No positions at time of writing.
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