ETFs and REITs

How an ETF works

An exchange-traded fund is a registered investment company whose shares trade on an exchange throughout the day. Most track an index; some are actively managed.

The mechanism that keeps the share price close to the value of the underlying portfolio is creation and redemption in kind. Large institutions called authorized participants may deliver a basket of the underlying securities to the fund in exchange for a large block of new ETF shares — a creation unit — or hand back a creation unit to receive the securities. If the ETF trades above the value of its holdings, an authorized participant creates new shares and sells them, pushing the price down; if it trades below, it buys shares and redeems them, pushing the price up. Arbitrage does the work that forward pricing does for a mutual fund.

The consequences for a customer:

Trading. ETF shares trade intraday at market prices, can be bought on margin, can be sold short, and can be traded with limit and stop orders. Mutual fund shares can do none of that; they price once a day under forward pricing.

Cost. Index ETFs generally carry low expense ratios, but the customer pays a commission or a spread on each trade, so frequent small purchases can cost more than a no-load fund.

Tax. In-kind redemption lets an ETF hand appreciated securities out rather than selling them, so index ETFs typically distribute far fewer capital gains than comparable mutual funds. The customer still pays tax on their own gain when they sell.

Pricing risk. An ETF can trade at a premium or discount to its intraday indicative value, particularly in thin markets or when the underlying market is closed — an international ETF trading while its home market is shut is the standard example.

Leveraged and inverse ETFs need separate treatment. They are designed to deliver a multiple, or the inverse, of an index's return over a single day, and they reset daily. Over any longer period, compounding means the return can diverge sharply from the multiple of the index's return over that period, and in a volatile sideways market the divergence is reliably negative. They are trading tools, not holdings, and recommending one as a long-term position is a suitability failure that FINRA has repeatedly disciplined firms over.

REITs

A real estate investment trust is a company that owns, and usually operates, income-producing real estate, or that lends against it. It gives investors exposure to commercial property in a liquid, divisible form.

The defining feature is the tax treatment. To qualify as a REIT under IRC section 856 and the sections that follow, a company must meet asset and income tests centred on real estate and must distribute at least 90 percent of its taxable income to shareholders each year. In exchange, it deducts those distributions and effectively avoids corporate-level tax on them. It is a conduit like a mutual fund — but note carefully that it is a conduit in one direction only. Income flows through; losses do not. A REIT is not a direct participation program, and it cannot pass depreciation losses to shareholders. That single distinction is the most reliable REIT question on the exam.

Three types. An equity REIT owns properties and derives income from rents; it is the majority of the market. A mortgage REIT holds mortgages and mortgage-backed securities and derives income from interest, which makes it interest-rate sensitive in a way an equity REIT is not. A hybrid REIT does both.

Distributions from a REIT are generally taxed as ordinary income rather than as qualified dividends, because the REIT paid no corporate tax on them. Part of a distribution may be classified as return of capital, which is not immediately taxable but reduces the shareholder's basis, and part as capital gain.

A listed REIT trades on an exchange like any equity and is priced continuously.

Non-traded REITs and the disclosure problem

A non-traded REIT is registered with the SEC and sold through broker-dealers, but its shares do not trade on any exchange. The structure has repeatedly produced customer harm and it belongs on the exam for exactly that reason.

The risks a representative must disclose. Liquidity: there is no secondary market, and the only exits are a share repurchase programme that is limited, may be suspended, and often prices below the offering price, or an eventual listing or liquidation that may be years away and is not guaranteed. Valuation: the price shown on a customer statement is an estimate produced by the sponsor, not a market price, and it can be stale. Costs: front-end fees and organizational costs can consume a substantial share of the money invested, so a customer's capital is working from a base well below what they contributed. Distributions: a non-traded REIT may pay distributions out of offering proceeds or borrowings rather than out of operating income — which means the customer is receiving their own money back and being told it is a yield.

That last point is the one to hold. A distribution rate is not a yield unless it is funded by operations, and the source is disclosed in the offering documents. A representative quoting a non-traded REIT's distribution rate to an income-seeking retiree without checking the source has made the classic mistake.

Business development companies raise the same set of issues in the corporate-lending context. A BDC is a closed-end fund that invests in the debt and equity of small and mid-sized private companies. Listed BDCs trade; non-traded BDCs share the non-traded REIT's liquidity and valuation profile.