Exchange-Traded Funds, Exchange-Traded Notes, and Unit Investment Trusts

Exchange-traded funds (ETFs)

Exchange-traded funds are becoming increasingly popular and are very similar to conventional open-end mutual funds in that they invest assets in a portfolio of securities, often—but not always—tracking an index. Among key differences are the fact that while conventional mutual funds are priced once a day after the market closes, ETFs are repriced and traded throughout the day. There also are structural benefits regarding how an ETF operates that often lead to lower fees compared with mutual funds investing in similar portfolios, as well as some tax efficiencies.

Exchange-traded notes (ETNs)

It sounds similar to an ETF but is actually quite different. An ETN essentially is a promissory note from a financial institution that matches the return of an index, minus fees. Like a bond, it has a maturity date, and like an ETF it can be traded throughout the day. The danger here is that an ETN is an unsecured obligation, meaning that if the financial institution issuing it can't meet its obligations, assets invested in the ETN may be lost. For that reason investing in an ETN entails a degree of credit risk along with the risk inherent in the performance of the index it tracks.

Unit investment trusts (UITs)

In the broadest sense, unit investment trusts are a type of investment company that holds a fixed portfolio of securities for a specified period of time. More specifically, it is also a structure used by some older ETFs that prevents them from making distributions until the end of each quarter, from holding securities not in the indexes they track, and from lending out securities. The inability to reinvest dividends daily, as newer ETFs and conventional mutual funds may do, can lead to tracking error, in which the ETF's performance diverges from its index. No new ETF has used this structure since 2002.