Exchange Traded Funds

<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 /> 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 /> <p class="PA"><span style="letter-spacing: .05pt">There are exceptions to the general tax rules for ETFs (discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7957">7957</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7958">7958</a>). Understanding the particular tax rules that apply to the sector in which the ETF belongs can help in understanding these exceptions, because if the ETF fits into certain market sectors, it must follow the tax rules that apply to that sector rather than the general tax rules. Currencies ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7960">7960</a>), futures ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7961">7961</a>), and metals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7962">7962</a>) are the sectors that receive special tax treatment.</span></p><br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">Futures ETFs trade in <a href="http://www.investopedia.com/terms/c/commodity.asp"><span style="color: black;text-decoration: none">commodities</span></a>, stocks, Treasury bonds, and currencies. For example, PowerShares DB Agriculture (AMEX:DBA) invests in futures contracts of agricultural commodities - corn, wheat, soybeans, and sugar - not the underlying commodities. Gains and losses on the futures within the ETF are treated as 60 percent long-term capital gain (or loss) and 40 percent short-term capital gain (or loss) regardless of how long the contracts were held by the ETF. Further, ETFs that trade futures follow <a href="http://www.investopedia.com/terms/m/marktomarket.asp"><span style="color: black;text-decoration: none">mark-to-market</span></a> rules at year-end. This means that any unrealized gains at the end of the year are taxed as though they were sold.</p><br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">ETFs track indexes which are, in turn, managed professionally and have teams of analysts and economists choosing the securities included in the index and the methodology for measuring the percentage of gain against base. Mutual funds pool investors&rsquo; funds and their professional managers select the securities, which the fund buys. The fund charges the investors a percentage of an investment pool for their services. This charge is called the &ldquo;load.&rdquo; Typically, the cost of the load for ETFs is lower than that of mutual funds. In theory, this should produce a higher yield for the individual or non-institutional investor over time. There are, however, some no-load mutual funds available.</p><br /> <p class="PA"><span style="letter-spacing: .1pt">ETFs are a much newer investment vehicle and have been available only for the last 30 years. Mutual funds have existed since the 1930s and, as a result, many have a long history with their institutional investors. For a less sophisticated investor, the process of purchasing and redeeming a mutual fund and the longer history of return that is available may be less intimidating. </span></p><br /> <p class="PA">ETFs appeal to sophisticated investors because they are more nimble. They can be traded throughout the day, purchased on margin, and sold short, while mutual funds cannot. ETFs also afford the individual investor access to myriad markets and asset classes.</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 /> <p class="PA"><span style="letter-spacing: .3pt">Because ETFs track particular indexes, they mirror the underlying index&rsquo;s diversification. Diversification is the term used in the financial world for a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind the technique is the theory that a portfolio of diverse investments will both yield a higher return over time and pose a lower risk of loss than any individual investment found within the portfolio. </span></p><br /> <p class="PA">Studies and mathematical models have shown that, over time, maintaining a well-diversified portfolio will yield a higher return and provide the most cost effective level of risk reduction. Most individual or non-institutional investors have limited investment budgets and may find it very difficult to independently create an adequately diversified portfolio.</p><br /> <p class="PA">Because ETFs are traded as securities on the public stock exchanges, individual and non-institutional investors can purchase shares in an ETF and obtain the benefit of its diversification together with the expertise of the analysts and economists who select the stocks and bonds in the index which the ETF tracks.</p><br /> <p class="PA">As an example, it would be very difficult for most individual investors to purchase shares in each of the companies listed in the Standard &amp; Poor&rsquo;s 500. ETFs can provide a method for individual investors to accomplish this level of diversification.</p><br /> <br /> </div><br />