TAX ADVANTAGES OF EXCHANGE TRADED PRODUCTS

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1 ETP TAX ADVANTAGES OF EXCHANGE TRADED PRODUCTS Due to their unique structure, exchange traded products (ETPs) are often seen as tax efficient investment vehicles. But not all ETPs are the same. Learn more about the five basic types of ETPs, the asset classes they invest in, how they work and their distinct tax implications. CONTENT Basic Types of Exchange Traded Funds and Exchange Traded Products... 4 Breakdown of Exchange Traded Products ETFs and Taxes Creation and Redemption Process... 8 Understanding Tax Liabilities... 9 Tax Harvesting This content is provided for informational purposes only. The contents are neither designed nor intended and should not be considered as, or relied upon as, investment, legal, tax or accounting advice or as a recommendation of any specific security or strategy. Investors should have a thorough understanding of the risks, as well as potential benefits, of the products and strategies referenced throughout this presentation and consult their financial advisor before deciding what, if any, course of action to take for their own particular situation. Published October FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC.

2 Exchange traded products (ETPs) have made a remarkable contribution to portfolio management for both retail and institutional investors. Known for offering transparency and low-cost exposure to hundreds of segments of the stock and bond markets, as well as to a variety of other alternative asset classes including commodities, real estate, and currencies, ETPs are also known for their tax efficiency.

3 TAX ADVANTAGES OF EXCHANGE TRADED PRODUCTS The tax advantages of many exchange traded products can enable them to further outdistance performance of traditional mutual funds that target the same indices. This difference can exceed 30 basis points a year. [See table below.] FIVE-YEAR TAX COST RATIOS: AVERAGE MUTUAL FUND VS. AVERAGE ETPs ANNUALIZED PERCENT LOSS DUE TO TAXES Fund category Average Mutual Fund Average ETP Difference Large Blend 2.30% 2.16% 0.14% Foreign Large Blend 1.73% 1.57% 0.15% Diversified Emerging Markets 1.63% 1.58% 0.05% Intermediate-Term Bond 2.09% 1.77% 0.32% SOURCE: Morningstar as of Assumes investor pays the top tax rates. The average mutual fund and ETP difference was calculated by substracting each category s post-tax five-year average annualized return from the average pre-tax five-year return. This benefit is largely achieved by delaying recognition of most capital gains to when investors sell out of the security. This is not the case for most mutual funds, especially those that are actively managed, whose underlying securities are often traded more frequently, which may generate more capital gains. For most ETPs, capital gains are lessened due to lower portfolio turnover in the products a benefit of the unique creation/redemption process associated with ETPs. It s important to note that ETP investors must pay tax on distributed dividends and interest. This feature is altering the way many high-end investors and advisors may have initially regarded ETPs. More than instruments that enable ordinary investors to access various segments of the market, ETPs are now appreciated as sophisticated investment products that can potentially enhance total returns. FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC. 2

4 BASIC TYPES OF EXCHANGE TRADED FUNDS AND EXCHANGE TRADED PRODUCTS The key to understanding the tax advantages of ETPs is to understand that there are various types with their own respective tax considerations [see table]. Investment Vehicle Registered Investment Companies/ Exchange Traded Funds SEC Act Structure/ Operation 1940 Most ETFs are passively managed seeking to replicate an index. Shareholders are allowed to reinvest dividends in the fund, but they are still distributed. A newer generation of funds are structured to be actively managed. However, increased transactions suggest increased tax liability. Types of Investments Distributions Taxation These products are primarily composed of stocks and bonds. ETFs enable investors to gain access to market indices around the world, ranging from small to largecap shares, across various industries and sectors, and to gain exposure to various segments of the U.S. and foreign bond markets. ETFs can invest in derivatives and loan securities. If the ETF has derivatives exposure, investors may be subject to embedded gains, even if the gains are unrealized. In-kind creation and redemption does not extend to derivatives. Derivatives transaction are always for cash and have a more immediate and significant impact to a fund s capital gains or losses than do the acquisition or disposal of securities in-kind. Dividends are paid monthly, quarterly, or annually. Realized net capital gains, distributed annually. ETFs deliver cheaper, more efficient, and profitable index exposure than is available through open-end funds. The key: transactions in existing fund shares do not result in transactions in underlying investments. ETFs defer recognition of most capital gains until investors cash out of the fund as a result of their lower internal turnover. Dividends are taxed as ordinary income. Shortterm capital gains are taxed as ordinary income. Long-term capital gains are taxed at the capital gains rate. If the ETF has derivatives exposure, any gains made are marked to market at the end of each year and passed on to its investors, potentially creating a taxable event. This means that investors may be subject to pay taxes on gains regardless of whether they sold their ETF shares or not. Additional Considerations Continuous offering and reduction in the number of outstanding shares achieved through creation/redemption process. Holdings are transparent. Investors can be long or short ETFs, the latter providing inverse exposure to the tracked index. Issues 1099s to shareholders. SOURCES: Mark Ascher, The Grantor Trust Rules Should be Repealed, Iowa Law Review, Vol. 96:885, p. 889.; org/wiki/exchange-traded_note 3 FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC.

5 BASIC TYPES OF EXCHANGE TRADED FUNDS AND EXCHANGE TRADED PRODUCTS (Continued) Investment Vehicle SEC Act Structure/ Operation Grantor Trusts 1933 Trusts issue shares that represent units of beneficial interest in and ownership of assets in the trusts. Trust may hold a single asset. There is no investment advisor. Portfolio composition doesn t change. Types of Investments Distributions Taxation They include alternative investments, such as currencies and precious metals. Dividends may be paid periodically; however, there is no requirement to distribute income. Whether distributed or not, investors are required to report their pro rata share of all income, expenses, capital gains and losses of the trust. Short-term capital gains are taxed at investors individual tax rates. Long-term capital gains are taxed at the current Federal tax rate. Additional Considerations Retail investors are not subject to the higher minimum contract sizes required for establishing positions in commodities or futures contracts. Issues 1099s to trust holders. Exchange Traded Notes (ETNs) 1933 Introduced in 2006, ETNs are structured investment products issued by major banks or providers in the form of senior, unsecured debt securities. They are linked to the performance of a market benchmark or strategy. Terms of the contracts are dictated by the ETN s structure. ETNs are long and short portfolios of commodities, currencies, equities, derivatives, and exotic investments, including volatility, weather, global warming, and carbon exposure. Provides exposure to hard-to-access asset classes without having to own the actual asset. Not usually. Though the tax treatment is uncertain, ETNs may be treated as prepaid contracts. Capital gains arise only from the sale of the ETN by the investor. Gains and losses would be characterized as short-term or long-term depending on the holding period and would be taxed accordingly. There has been no administrative or judicial ruling that directly addresses the tax treatment of ETNs. The Internal Revenue Service may determine a specific treatment that could be different from the way investors account for ETNs currently. ETNs have certain disadvantages compared to other products, including counterparty risk (because the investment is unsecured debt) and uncertain tax treatment. SOURCES: Mark Ascher, The Grantor Trust Rules Should be Repealed, Iowa Law Review, Vol. 96:885, p. 889.; org/wiki/exchange-traded_note FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC. 4

6 BASIC TYPES OF EXCHANGE TRADED FUNDS AND EXCHANGE TRADED PRODUCTS (Continued) Investment Vehicle Publicly Traded Partnerships (PTP) SEC Act Structure/ Operation 1933 PTPs issue shares that represent units of beneficial interest in and ownership of assets contained within the partnership. Partnerships provide exposure to hard-toaccess asset classes without involving possession of actual assets. Types of Investments Distributions Taxation Currently dominated by commodities, partnerships also offer access to long-short equity and market neutral investments. Distributions made by the PTPs, if any, are not taxed to investors, but are rather treated as a cost basis adjustment (reduction) of the PTP units. Investors are required to report their pro-rata share of the partnership s income and capital gains on an annual basis, whether or not cash is distributed by the partnership. Additional Considerations K-1 Forms are sent each year to investors by April 15 or later. This can result in investors needing to delay the filing of their taxes. Active portfolio management is allowed. Unit Investment Trusts 1940 UITs are prepackaged holdings of securities, which mature as a unit. Proceeds from maturity can be returned to the investor or reinvested in a new UIT. They typically involve stocks and bonds. UITs do not reinvest dividends, but hold until they re paid to shareholders quarterly or annually. Whether distributed or not, investors have a tax liability as income is generated. If the UIT is a regulated investment company (RIC) net income has to be distributed. They may have capital gains liability if securities are sold for a profit. Because UITs have to hold on to income distributions in cash (i.e. they are not permitted to equitize in any way) as they wait to reinvest, this may cause them to underperform their benchmarks in a rising stock market and outperform in a falling one. SOURCES: Mark Ascher, The Grantor Trust Rules Should be Repealed, Iowa Law Review, Vol. 96:885, p. 889.; org/wiki/exchange-traded_note 5 FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC.

7 BREAKDOWN OF EXCHANGE TRADED PRODUCTS Fund Type Number of Providers Number of Funds Total Assets (in $millions) Open-end Investment Company 36 1,325 2,598,652 Uncollateralized Debt Instrument ,514 Partnership (3C1) ,887 Grantor Trust ,071 Unit Investment Trust ,200 SOURCE: Morningstar. Data as of FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC. 6

8 ETFS AND TAXES ETFs trade on an exchange like a stock, so investors can buy and sell ETFs without causing the fund manager to raise cash to meet redemptions, thereby creating a taxable event. Often ETFs are more tax efficient than a mutual fund because shareholder activity, and resulting portfolio turnover, do not affect portfolio management in the same manner and as a result of the lower internal turnover of index strategies, the predominant focus of ETFs. Therefore, the after tax results of a comparably managed ETF and mutual fund can be quite different. CREATION AND REDEMPTION PROCESS When an investor acquires shares in an open-end mutual fund, the portfolio manager takes the proceeds and buys underlying positions. When an investor redeems shares in a mutual fund, the portfolio manager sells the underlying positions to raise cash, potentially realizing capital gains that would be distributed to all shareholders. An exchange traded fund (ETF) typically has several initial investors who are designated as authorized participants (APs). An AP has the ability to create units based on investor interest. A creation unit is typically in either 50,000 or 100,000 share increments. When there is sufficient interest from investors, an AP can buy a basket of the underlying constituents, and deliver to the fund. The fund then creates the necessary number of shares for the AP. The size of the fund and the number of creation units grows as there is increased interest in the strategy. Conversely, when an AP wants to redeem shares, the fund delivers a basket containing the appropriate amount of shares of the underlying constituents and redeems the necessary number of shares of the ETF from the AP in return ( redemption unit ). Redemptions are in the form of an in-kind transfer and not taxable events. The average investor merely buys or sells shares in the market; the creation and redemption process goes on behind the scenes. Investors must be mindful, however, that their most significant capital gains exposure comes when selling their ETPs above their own original cost. 7 FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC.

9 UNDERSTANDING TAX LIABILITIES Unlike mutual funds where investor selling may trigger the sale of underlying assets by the fund provider to meet redemptions, ETF trades are between shareholders. They would typically not require the fund provider to alter the portfolio to support such transactions. For passively-managed index ETFs, there are two reasons that an ETF might sell or buy securities that would result in the fund realizing a gain or a loss. They both involve changes in the index which the ETF tracks. They are not typically executed by an AP but by the ETF provider itself. This is what makes such changes taxable events. 1. The first event is a corporate action, such as a merger, acquisition, or a spinoff. For a market-weighted ETF, a constituent stock that is taken over by a company that s not in the index [e.g., because it is foreign and the index is domestic] would need to be sold. Another example is if a company spun off part of itself, requiring a pro-rated portion of the stock to be sold. 2. The second event involves normal portfolio rebalancing. Any weighted index [e.g., market-cap or equal weight] needs to be rebalanced periodically as weightings within an index (and its reflective ETF) changes and it must rebalance back to its desired weighting. The number of tax events can significantly increase when dealing with actively-managed ETFs and ETPs that rely on short-term derivative contracts. These include commodity, currency, leveraged and short ETPs. Their values are marked to market, with investors paying taxes annually at ordinary rates on realized and unrealized gains. In considering specific asset exposure such as commodities, investors and advisors need be mindful of differences among various exchange traded products. For example, commodity ETPs that use off-shore special purpose vehicles to gain derivative exposure in the desired asset spin off ordinary income but not dividend income, which is treated as non-qualified income. Other commodity ETPs use structured notes a form of debt instrument that generate capital gains and interest income that are also recognized annually and are taxed at their respective rates. In contrast, a Grantor Trust that holds the actual hard asset such as currency, gold or silver doesn t use contracts. (The exception is currency ETPs, which may generate interest income, which is taxable.) They don t generate income or a related tax liability. When investors sell and realize a capital gain after holding the security for more than a year, it is taxed at what s known as the collectibles rate. But when held for less than a year, investors are taxed at their marginal ordinary income tax rate. Then there are commodity partnerships that generate only minimal annual tax liability when selling assets to cover operating expenses. When dealing with any exchange traded products, especially those that regularly spin off significant income or capital gains, investors and advisors need to determine the most appropriate type of account to use individual, tax-deferred, or after-tax accounts. This decision should be based on an investor s current income needs, investment time horizon, and his or her marginal tax rate. FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC. 8

10 TAX HARVESTING The wide range and number of exchange traded products makes them very useful when harvesting losses to shelter gains and up to $3,000 of income. When a particular stock, bond or commodity falls below the purchase price, investors can lock in a loss without losing desired market exposure that the security is providing by immediately replacing it with an ETF. For example, if an investor in a particular bank stock that is off 30% wants to maintain exposure in the event of an industry rally but wants to capture the tax loss to offset income elsewhere in his portfolio, he can replace the security with a financial ETF that delivers correlated performance. While not a perfect substitute, an ETF with focused exposure to the same market segment should react in similar ways to factors impacting the segment. The same can be done with an ETF that is significantly off from the price paid. But in both instances, the newly acquired ETF has to be deemed different enough to avoid triggering the Wash Sale rule. An investor can t buy back the position or something very much like it, for 30 days prior to or 30 days following the sale date. Otherwise, such a purchase washes away the tax benefits associated with the realized loss. The purchase of a financial sector fund would not disqualify a loss taken on a bank stock. But investors need to be careful in replacing one financial sector product with another that delivers comparable exposure. In switching financial funds, a global sector fund could replace a domestically-focused fund. Tax advisors should be consulted to ensure a replacement purchase does not run afoul of the wash sale rule. Another point to keep in mind when selling is to avoid year-end fund distributions. These are typically comprised of capital gains whose value is embedded in a fund s price before distribution. Selling before distribution, as well as buying for replacement purposes after distribution is made, should enable investors to retain more value by avoiding payment of taxes on such distributions. Another caveat: investors must be sure that the fund they are temporarily selling out of is not closed to new investors. If it is, then they would not be able to buy it back, even after the wash sale period expires. UNDERSTANDING THE DIFFERENCES BETWEEN EXCHANGE TRADED PRODUCTS IS IMPORTANT ETPs are more than simple and convenient investment products. Tax efficiency has added to their appeal. And their success has fueled expansion and evolution into more sophisticated securities. This makes it more incumbent than ever for investors and advisors to understand the differences between the different types of exchange traded products to ensure purchase of the most desirable asset exposure, tax consequences and total returns. 9 FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC.

11 About Guggenheim Investments ETFs Guggenheim Investments offers investors a broad range of ETFs domestic and international equity, fixed-income and currency to provide the core building blocks for portfolios, access to hard-to-reach market segments, as well as targeted investment choices. As the eighth-largest U.S. ETF provider with approximately $18 billion in assets*, Guggenheim Investments seeks to be a go-to source for strong, actionable ideas to the marketplace. With a history of purposeful innovation, including many industry firsts, Guggenheim Investments delivers what we believe are distinct and relevant strategies for institutional investors, private wealth advisors and the clients they serve. Our clients value our commitment to the intelligent pursuit of wealth and our traditions of independence, thought leadership and nimbleness. For more information, visit guggenheiminvestments.com. * Source: Blackrock, September 2013 Any overviews herein are intended to be general in nature and do not constitute investment, tax or legal advice. Please consult your tax advisor and/or state and local tax offices for more complete information. RISKS AND OTHER CONSIDERATIONS The information contained herein is for educational and illustrative purposes and should not be regarded as tax advice. While exchange traded products discussed may have some tax-efficient attributes, these product structures were not designed with tax benefits as an objective. If shares of an exchange traded product are sold at a price other than their purchase price, the transaction will typically represent a taxable event. This information does not represent an offer to sell securities of any fund and it is not soliciting an offer to buy securities of Guggenheim Investments products. There can be no assurance that an exchange traded product will achieve its investment objective(s). There are risks involved with investing, including, but not limited to, investment risk, which is the possible loss of the entire principal amount you invest. There is a risk that the value of the securities held by an exchange traded product will fall due to general market and economic conditions, perceptions regarding the industries in which the issuers of securities held by the exchange traded product participate, or factors relating to specific companies in which the exchange traded product invests. Please read a prospectus before investing. Read a fund s prospectus and summary prospectus (if available) carefully before investing. It contains the fund s investment objectives, risks, charges, expenses and other information, which should be considered carefully before investing. Obtain a prospectus and summary prospectus (if available) at guggenheiminvestments.com. Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC. Securities offered through Guggenheim Funds Distributors, LLC and Guggenheim Distributors, LLC. Guggenheim Distributors, LLC and Guggenheim Funds Distributors, LLC. are affiliated with Guggenheim Partners, LLC. FOR FINANCIAL REPRESENTATIVE USE ONLY. DO NOT DISTRIBUTE TO THE PUBLIC. 10

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