Exchange Traded Funds

<div class="Section1"><br /> <br /> A leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.<br /> <br /> A leveraged ETF does not amplify the annual returns of an index; instead it follows the daily changes. For example, in the case of a leveraged fund with a 2:1 ratio, each dollar of investor capital used is matched with an additional dollar of invested debt. On a day in which the underlying index returns 1 percent, the fund will theoretically return 2 percent. The 2 percent return is theoretical, as management fees and transaction costs diminish the full effects of leverage.<br /> <br /> The 2:1 ratio works in the opposite direction as well. If the index drops 1 percent, the fund&rsquo;s loss would then be 2 percent.<br /> <br /> Leveraged funds have been available since the early 1990s. The first leveraged ETFs were introduced in the summer of 2006, after being reviewed for almost three years by the Securities and Exchange Commission. The goal of a leveraged ETF is for future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.<br /> <br /> The typical holdings of a leveraged index fund would include a large amount of cash invested in short-term securities, and a smaller, but highly volatile, portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.<br /> <br /> A derivative is a security whose price is dependent upon or derived fromone or more underlying assets.The derivative itself is merely a contract between two or more parties. Itsvalue is determinedby fluctuationsin the underlying asset.The most common underlying assets includestocks, bonds,commodities,currencies, interest rates, and market indexes. Most derivatives are characterized by high leverage.<br /> <br /> There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> A short sale is a market transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares to the lender at some point in the future. This is known as &ldquo;selling short.&rdquo;<br /> <br /> The payoff to selling short is the opposite of a long position. A short seller will profit if the value of the stock declines, while the holder of a long position profits when the stock value increases. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares for repayment to the lender at a later date.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Like purchasing on margin, this is a higher risk investment strategy that, if executed properly, can produce a high profit, thus making ETFs a more attractive strategy for sophisticated investors. Mutual funds cannot be sold short.<br /> <br /> <hr><br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">A Double Gold ETF is an exchange-traded fund that tracks the value of gold and responds to movements in the same manner as an otherwise similar double leveraged ETF. A double gold ETF is one in which the spot value of gold or a basket of gold companies acts as the underlying asset for the fund. The ETF attempts to deliver price movements that are twice the value of the movements of the underlying gold.</p><br /> <p class="PA">It is important to note that even though there is a potential for recognizing significant profits with this strategy, the risk of loss is also significant because the price could fall dramatically. Double gold ETFs are by no means a unique fund product. There are numerous leveraged ETFs that aim to deliver movements equal to two or more times the movements of their underlying assets. Some examples include leveraged ETFs on natural gas and crude oil. These ETFs can also aim to mimic an inverse movement relative to the underlying assets; such ETFs are known as inverse or bear ETFs.</p><br /> <p class="PA"><span style="letter-spacing: .2pt">It is also important to remember that trades or investments in gold are treated &ldquo;collectibles&rdquo; for tax purposes. The same applies to ETFs that trade or hold gold. As a collectible, if gain is short-term, then it is taxed as ordinary income. If gain is earned over a period spanning more than one year, then it is taxed at one of three long-term capital gains rates, depending on the investor&rsquo;s income tax bracket. This means that investors cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold for shorter-term investment.</span></p><br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Investors who hold securities in brokerage accounts can use their portfolios as collateral for loans from the brokerage for purchasing additional securities. These loans and cash for the purchase of securities are held in accounts known as &ldquo;margin accounts.&rdquo; Using margin accounts effectively allows investors to use their brokerage&rsquo;s cash to buy securities and leverage their gains.The dollar amount that is currently available in a margin account for the purchase of securities or for withdrawal from the account using the portfolio as collateral is the &ldquo;margin loan availability.&rdquo;<br /> <br /> The margin loan availability will change daily as the value of margin debt (which includes purchased securities) changes.<br /> <br /> If the margin loan availability amount in an investor&rsquo;s account becomes negative, the investor may be due for a margin call, which is a formal request that the investor sell some of the marginable securities in order to repay the brokerage.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Purchasing on margin is a higher risk strategy that if executed properly can produce large profits. The fact that ETFs can be purchased on margin makes them more attractive to investors using this strategy. Mutual funds cannot be purchased on margin.<br /> <br /> <hr><br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Currency ETFs allow investors to invest in foreign currencies in the same manner as with stocks or any other ETF.<br /> <br /> Currency ETFs replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked, or using futures contracts on the underlying currency.<br /> <br /> Either way, these methods should provide a highly correlated return to the actual movements of the currency over time.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> These funds typically have low management fees, as there is little management involved in the funds, but investors should be advised to examine the fees before purchasing.<br /> <br /> <hr><br /> <br /> There are several choices of currency ETFs in the marketplace, including ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If an investor believes that the Swiss franc is set to rise against the U.S. dollar, he or she may want to purchase this ETF, while a short sell on the ETF can be placed if an investor believes that the Swiss currency is set to fall.<br /> <br /> ETFs that track a basket of different currencies are also available. For example, the PowerShares DB U.S. Dollar Bullish (NYSE:UUP) and Bearish (NYSE:UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. If an investor believes that the U.S. dollar is going to fall broadly, it may be advisable to purchase the Powershares DB U.S. Dollar Bearish ETF.<br /> <br /> There are even more active currency strategies used in certain currency ETFs.<br /> <br /> In general, much like other ETFs, when a currency ETF is sold, if the foreign currency has appreciated against the dollar, the sale will produce a profit. On the other hand, if the ETF&rsquo;s currency or underlying index has declined relative to the dollar, a loss is generated.<br /> <br /> There is, however, a difference in how these profits are taxed. Most currency ETFs are in the form of grantor trusts. This means that the profit from the trust creates an ordinary income tax liability for the underlying ETF shareholder (as a result of the general tax rules that apply to grantor trusts). ETFs that are organized as grantor trusts are not eligible for the typically favorable long-term capital gains rates, even if the ETF is held for a period of several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> One of the advantages of owning ETFs is their tax efficiency.<br /> <br /> ETFs enjoy a more favorable tax treatment than mutual funds due to their unique structure. Mutual funds create and redeem shares with in-kind transactions that are not considered sales. As a result, they do not create taxable events. However, when an ETF is sold, the trade triggers a taxable event. Whether it is a long-term or short-term capital gain or loss depends on how long the ETF was held. In the United States, a taxpayer must hold an ETF for more than one year to receive long-term capital gains treatment. If the security is held for one year or less, then it will receive short-term capital gains treatment.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Long-term capital gains are normally taxed at a favorable rate of 20 percent, 15 percent or 0 percent, depending on the taxpayer&rsquo;s income tax bracket. These favorable rates were made permanent for tax years beginning after 2012.<br /> <br /> <hr><br /> <br /> As with stock, taxpayers are subject to the <a href="http://www.investopedia.com/terms/w/washsalerule.asp">wash-sale rules</a> if an ETF is sold for a loss and then repurchased within 30 days. A wash sale occurs when a taxpayer sells or trades a security at a loss and, within 30 days after the sale, the taxpayer:<br /> <ul><br /> <li>Buys a substantially identical ETF;</li><br /> <li>Acquires a substantially identical ETF in a fully taxable trade; or</li><br /> <li>Acquires a contract or option to buy a substantially identical ETF.</li><br /> </ul><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> If a loss was disallowed because of the wash-sale rules, the taxpayer should add the disallowed loss to the cost of the new ETF. This increases the <a href="http://www.investopedia.com/terms/b/basis.asp">basis</a> in the new ETF. This adjustment postpones the loss deduction until the disposition of the new ETF. The <a href="http://www.investopedia.com/terms/h/holdingperiod.asp">holding period</a> for the new ETF begins on the same day as the holding period of the ETF that was sold.<br /> <br /> <hr><br /> <br /> Many ETFs generate <a href="http://www.investopedia.com/terms/d/dividend.asp">dividends</a> from the stocks they hold. Ordinary (taxable) dividends are the most common type of distribution from a corporation. According to the IRS, a taxpayer can assume that any dividend received on common or preferred stock is an ordinary dividend unless the paying corporation specifies otherwise. These dividends are taxed when paid by the ETF as ordinary income.<br /> <br /> <a href="http://www.investopedia.com/terms/q/qualifieddividend.asp">Qualified dividends</a> are subject to the same maximum tax rate that applies to net capital gains. In order to qualify:<br /> <ol><br /> <li>An American company or a qualifying foreign company must have paid the dividend.</li><br /> <li>The dividends must not be listed with the IRS as dividends that do not qualify.</li><br /> <li>The required dividend holding period must be met.</li><br /> </ol><br /> The ETF provider should specify whether the dividends that have been paid are ordinary or qualified.<br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">Most currency ETFs are formed as grantor trusts. This means the profit from the trust creates ordinary income tax liability for the individual ETF shareholder based on the rules that apply to grantor trusts. As a result, currency ETFs are not eligible for favorable long-term capital gains treatment, even if the ETF is held for several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods of time.</p><br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">Individual taxpayers who trade or invest in gold, silver, or platinum bullion are subject to the IRS&rsquo; rules that govern &ldquo;collectibles&rdquo; for tax purposes. The same rules apply to ETFs that trade or hold gold, silver, or platinum. Under the rules that apply to collectibles, if gain is short-term, it is taxed as ordinary income. If gain is earned over a period that spans more than one year, then it is taxed at one of three capital gains rates, depending on the taxpayer&rsquo;s income tax bracket. This means that taxpayers cannot take advantage of the normal capital gains tax rates on investments in ETFs that invest in gold, silver, or platinum. The ETF provider will specify what is considered short-term and what is considered long-term gain or loss.</p><br /> <br /> </div><br />

<div class="Section1">ETFs have several advantages over mutual funds, including the following:<br /> <ul><br /> <li>They are easy to trade: they can be bought and sold anytime through any broker, just like a stock.</li><br /> <li>They are tax efficient: ETFs typically have lower portfolio turnover and strive to minimize capital gains distributions so that investors are only taxed when they initiate a trade. Note: There are special rules for currency, commodity, and metals ETFs that cause them to be taxed in the same way as the underlying class of investment (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7959">7959</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7962">7962</a>).</li><br /> <li>Greater Transparency: ETFs disclose the exact holdings of their funds on a daily basis so the investor always understands precisely what he or she owns.</li><br /> <li>Flexibility: Any action that an investor can take with respect to stock can be accomplished with an ETF. This includes shorting and holding ETFs in margin accounts and placing limit orders.</li><br /> </ul><br /> </div><br />

<div class="Section1"><br /> <br /> ETF shares represent undivided interests in the assets held by the fund. ETFs are &ldquo;organized either as open-end investment companies or unit investment trusts.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> ETFs organized as unit investment trusts (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7973">7973</a>) generally qualify for tax treatment as regulated investment companies (RICs) for tax purposes. For the treatment of dividends, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a>.For the treatment of capital gain on the sale or exchange of exchange-traded shares, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7949">7949</a>.For the treatment of capital gains and losses, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7935">7935</a> for a discussion of the specific rules applicable to RICs.<br /> <br /> <em>Exchange-Traded Funds Invested in Metals</em>. In a memorandum prepared by the Office of Chief Counsel of the IRS, which was made public only as the result of a court order, the IRS advised that the sale of an interest in an ETF that directly invests in metal (&ldquo;physically-backed metal ETF&rdquo;) is treated as the sale of a &ldquo;collectible&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>), such that any gain from the sale of the interest is subject to the maximum capital gains rate of 28 percent (i.e., instead of the 20/15/0 percent capital gains rate (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>)).<a href="#_ftn2" name="_ftnref2">²</a> The Service reasoned that in the case of a physically-backed metal ETF that is treated as a trust, the investor is treated as owning an undivided beneficial interest in the collectible held by the trust. Accordingly, if the investor sells an interest in the ETF or the trust sells a portion of the collectible, the investor is treated as having sold all or a portion of his or her share of the collectible held by the trust, and any gain from the sale of the trust interest or sale of the collectible by the trust is treated as collectible gain and, therefore, is subject to the maximum capital gains rate of 28 percent. However, if a physically-backed metal ETF is not structured as a trust, or if the ETF does not directly invest in the metal, then the above rule does not apply. The Service cautions that the structure of each physically backed metal ETF should be considered to determine the tax consequences of an investment in that ETF.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. <em>Exchange-Traded Funds, Proposed Rule</em>, 73 Fed. Reg. 14618, 14619 (Mar. 18, 2008), Footnote 8.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. Office of Chief Counsel IRS Memorandum by TaJuana Nelson Hyde, Assistant Branch Chief (May 2, 2008), &ldquo;Exchange-Traded Funds Invested in Metal (<em>Wall Street Journal</em> Article).&rdquo;<br /> <br /> </div></div><br />