This SIE study guide page covers everything about exchange-traded products (ETPs), such as exchange-traded funds and exchange-traded notes (ETNs). You must thoroughly study this topic to score high on the SIE exam.
Exchange-traded Products (ETPs)
Exchange-traded products (ETPs) funds track underlying securities, indices, or other financial instruments. These funds are traded on stock exchanges like individual stocks, and their price fluctuations are based on the price of underlying securities.
For example, the price of Apple Inc.’s (AAPL) ETPs fluctuates with the stock price fluctuations of AAPL. I advise you to read our previous SIE guide on packaged products for more information.
The exchange-traded products (ETPs) are categorized into two segments:
- Passively Managed ETPs: The passively managed exchange-traded products aim to replicate the benchmark performance of tracking underlying assets.
- Actively Managed ETPs: The actively managed exchange-traded products aim to outperform the benchmark performance of tracking underlying assets.
Exchange-traded Funds (ETFs)
Exchange-traded funds (ETFs) are packaged products traded on stock exchanges, like individual stocks. They hold a diversified portfolio of assets, such as stocks, bonds, or commodities, and typically track an index.
Exchange-traded funds offer diversified portfolios like mutual funds, but they are available to trade in real-time and require lower investment minimums and brokerage charges.
They suit individual and institutional investors seeking diversified and cost-effective investment options.
Features of exchange-traded funds (ETFs):
- Exchange-traded funds offer diversified portfolios like mutual funds but can be traded in intraday due to real-time pricing.
- Exchange-traded funds are considered more liquid than mutual funds.
- ETFs, like stocks, can be purchased or sold anytime in a day, but mutual funds can only be bought or sold at the end of the day.
- If an investor buys ETFs on an exchange, it buys the fund itself rather than its underlying assets.
ETF Tax Treatment
ETFs are generally tax-efficient, but investors are still subject to capital gains taxes when they sell ETF shares at a profit. In this section, we’ll learn about tax treatments of stock and bond ETFs.
Stock ETFs
Stock ETFs are designed to track the performance of a specific stock index or sector. They are popular among investors due to their diversification, liquidity, and cost-effectiveness.
- Long-Term Capital Gains: If an investor holds shares of a Stock ETF for more than one year before selling, any gains realized are subject to long-term capital gains tax rates, typically lower than ordinary income tax rates.
- Short-Term Capital Gains: If an investor sells Stock ETF shares after holding them for one year or less, the gains are taxed as short-term capital gains at ordinary income tax rates.
- Qualified Dividends: Dividends paid by Stock ETFs that meet specific criteria (e.g., the underlying stocks are held in a particular period) are considered qualified dividends and are taxed at the lower long-term capital gains tax rates.
- Non-Qualified Dividends: Dividends that do not meet the criteria for qualified dividends are taxed at ordinary income tax rates.
- Foreign Taxes: Foreign taxes may be withheld on dividends if a Stock ETF holds international stocks. Investors may be eligible for a foreign tax credit to offset some or all of the foreign taxes paid.
Bond ETFs
Bond ETFs invest in a portfolio of bonds, offering exposure to fixed-income markets. The tax treatment of Bond ETFs is influenced by the type of bonds they hold and the interest income they generate.
- Taxable Bonds: Interest income from taxable bonds (e.g., corporate bonds, U.S. Treasury bonds) held within a Bond ETF is taxed at ordinary income tax rates. This interest income is typically distributed to investors as dividends.
- Municipal Bonds: Interest income from municipal bonds held within a Bond ETF is generally exempt from federal income taxes and, in some cases, state and local taxes, depending on the investor’s residence and the source of the bonds. However, this tax-exempt income may be subject to the Alternative Minimum Tax (AMT).
- Long-Term Capital Gains: Similar to Stock ETFs, gains from the sale of Bond ETF shares held for more than one year are subject to long-term capital gains tax rates.
- Short-Term Capital Gains: Gains from the sale of Bond ETF shares held for one year or less are taxed as short-term capital gains at ordinary income tax rates.
Exchange-traded Notes (ETNs)
Exchange-traded notes (ETNs) are a type of unsecured debt security issued by financial institutions that aim to track the performance of a specific market index or benchmark.
ETNs are traded on stock exchanges, similar to exchange-traded funds (ETFs), but differ significantly in structure and risk profile. They are designed to provide returns that mimic the performance of an underlying index or benchmark.
- Unsecured Debt Obligation: ETNs are unsecured and backed only by the creditworthiness of the issuing institution. This means that ETNs carry issuer credit risk, where the note’s value depends on the issuer’s ability to meet its financial obligations.
- No Underlying Assets: ETNs do not hold physical assets or securities. Instead, they are structured to deliver the performance of a specific index, such as commodities, currencies, or market volatility indices.
- Maturity Date: ETNs have a maturity date ranging from a few years to several decades (typically 15 to 30 years from the original issuance date). At maturity, the issuer pays the note’s value based on the performance of the underlying index.
- Fees: ETNs typically charge an annual fee deducted from the note’s performance. These fees can impact the overall return of the ETN.
Unlike ETFs, which hold a portfolio of assets, ETNs are debt obligations of the issuer and do not own any underlying assets. The issuer promises to pay the index’s return, less any fees, upon maturity of the note.