Section 6.3: REITs, ETFs, and ETNs

  • This section covers three major investment vehicles often compared with mutual funds or traditional securities:

    • Real Estate Investment Trusts (REITs), Exchange-Traded Funds (ETFs), and Exchange-Traded Notes (ETNs).

🏒 Real Estate Investment Trusts (REITs):

  • A Real Estate Investment Trust (REIT) is a company that owns or manages a portfolio of real estate, mortgages, or both to earn profits for shareholders.

  • REITs are structured much like closed-end funds, but:

    • They are not investment companies, because they do not hold other securities (they hold real estate or mortgages).

    • They are organized as trusts, not corporations.

How REITs Work:

  • Investors buy shares or certificates in the REIT (publicly traded or OTC).

  • REITs pool capital from many investors, similar to mutual funds.

  • REITs pay out income to shareholders in the form of dividends.

Types of REITs

Type / Description / Primary Income

  • Source Equity REITs / Own and operate income-producing properties (like apartments, malls, offices). / Rental income

  • Mortgage REITs / Invest in mortgages or mortgage-backed securities. / Interest income

  • Hybrid REITs / Combine both ownership of properties and mortgage investments. / Rental + interest income

Public vs. Private REITs

  • Public REITs are Registered with the SEC, and traded on exchanges or OTC

  • Private REITs are NOT Registered with the SEC, and not publicly traded (illiquid)

Tax Treatment – Conduit Tax Theory (Subchapter M):

  • REITs operate under the Conduit Theory, which allows income to β€œflow through” to shareholders.

  • If a REIT distributes at least 90% of its taxable income to shareholders:

    • It avoids paying corporate income tax, and

    • Investors are taxed only once at the individual level.

  • This helps avoid triple taxation (corporate, fund, and investor levels).

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πŸ” Exchange-Traded Funds (ETFs)

  • ETFs are open-end investment companies or unit investment trusts (UITs) that trade like stocks on exchanges.

  • They are designed to track an index, such as:

    • S&P 500

    • Nasdaq-100

    • Sector-specific or international indexes

Comparison to Mutual Funds

Feature / Mutual Fund (Open - End Fund) / ETF

  • Structure / Open-end investment company / Open-end fund or UIT

  • Trading / Purchased/redeemed at end of day (NAV) / Trades all day on exchanges

  • Pricing / Priced once daily at NAV / Market price changes intraday

  • Margin Trading / Not allowed / Allowed (can be shorted)

  • Commissions / None (usually no-load) / Pay commissions on each trade

  • Tax Efficiency / More taxable events (due to fund turnover) / Fewer taxable events (less turnover)

  • Management Style / Often actively managed / Usually passively managed (index-based)

Advantages of ETFs

  • Intraday trading – Can buy/sell throughout the day at market prices.

  • Margin and short selling allowed – Flexibility for traders.

  • Low operating expenses – Typically lower management fees than mutual funds.

  • Tax efficiency – Low turnover minimizes taxable capital gains.

  • Diversification – Tracks a full index or sector.

Disadvantages of ETFs:

  • Commissions – Each buy/sell transaction has a commission cost, which adds up over time.

  • Market influence – ETF prices can be affected by supply and demand (may trade at a premium or discount to NAV).

  • Small investment inefficiency – Frequent trading or small investments can erode the cost advantage..

πŸ’΅ Exchange-Traded Notes (ETNs):

  • Exchange-Traded Notes (ETNs) are unsecured debt securities issued by banks or financial institutions.

  • They are designed to track the performance of a market index, commodity, or benchmark β€” without ownership in any underlying assets.

ETN Key Features

Feature / ETN Description

  • Issuer / Bank or financial institution

  • Backing / Only by the issuer’s credit (no collateral) Maturity Fixed maturity date

  • Interest Payments / None (no periodic interest)

  • Principal Protection / None

  • Return / Based on performance of underlying index, minus fees

  • Taxation / No annual interest; any gain or loss realized at maturity or sale

Risks of ETNs:

  • Credit Risk – Since ETNs are unsecured debt, if the issuing bank defaults, investors could lose principal.

  • Market Risk – Returns depend on the underlying index’s performance.

  • Liquidity Risk – Some ETNs trade thinly in the secondary market.

Quick Review of Related Concepts:

  • Closed-End Fund:

    • Issues a fixed number of shares through an IPO.

    • Shares trade on exchanges like stocks.

    • Prices determined by market supply/demand, not NAV.

    Open-End Investment Company (Mutual Fund):

    • Continuously issues and redeems shares at end-of-day NAV.

    • Shares are bought/sold directly with the fund.

    Conduit Tax Theory (Subchapter M):

    • Investment income passes through the fund or trust to investors, avoiding double or triple taxation.

Chapter 7

✺ Review questions ✺

  • Real estate, mortgages, or both.

  • No, because their portfolios hold real property, not securities.

  • Equity REITs, Mortgage REITs, and Hybrid REITs.

  • Double or triple taxation, if they distribute at least 90% of taxable income to shareholders.

  • ETFs trade like stocks on exchanges throughout the day, while mutual funds are priced once daily at NAV.

  • Yes

  • Commissions on each trade can reduce cost advantages.

  • The good faith and credit of the issuing bank (they are unsecured debt).

  • No, returns are based on the performance of the underlying index, paid at maturity.

  • Credit risk (issuer default) and market risk (underlying index performance).