AMLP’s Dirty Little Secret

September 24, 2010 by  
Filed under Commentary, ETFs

$128 million can’t be wrong – or can it?  Since its launch on August 25, 2010, the Alerian MLP ETF (AMLP) has attracted an impressive amount of assets, nearly $128 million in less than a month.  However, shareholders appear to be oblivious to the fact that AMLP employs a 62.5% daily leverage factor, thereby giving shareholders a 37.5% daily haircut.

Upon its arrival, AMLP was heralded by scores of analysts as the best way for investors to gain access to the performance of Master Limited Partnerships, more commonly referred to as MLPs.  My voice was a lonely one, telling investors to beware because I believed the marketing materials were misleading and AMLP’s structure would make its performance fail to meet its objective.

My original analysis was published in “Beware of MLPs in ETF Wrappers: AMLP” dated August 27.  In it, I alleged the corporate tax structure chosen by AMLP would be a hindrance to its performance versus the “pass-through” structures of other ETFs and ETNs.  I also argued the marketing materials were misleading because they claimed AMLP would track the underlying Alerian MLP Infrastructure Index before fees and total expenses of 0.85%.  There was no accounting for the 35% corporate tax impact.

Representatives from both Alerian and ALPS contacted me regarding the story and ALPS (the fund’s advisor and distributor) eventually provided a written response on August 30.  I published “ALPS Responds To AMLP Article” on September 3.  I do not believe they adequately addressed any of the concerns I raised, but I will let you read it for yourself and draw your own conclusions.

Part of their reply included the assertion that MLPs packaged inside an ETF had long eluded many financial institutions that had “been trying for years to unlock the secret to an [MLP] ETF, long before the ETN ever came out… fortunately, MSSRS Hammond and Feng [Alerian executives] finally figured out the key to the ETF structure”.

I have figured out the secret too:  AMLP’s daily NAV is calculated with a 62.5% leverage factor.

First of all, investors must understand that when tracking an index, all ETFs employ leverage.   In the vast majority of cases the leverage is 1x (or 100%) and the ETF seeks to track 100% of the daily change of the underlying index.  Many investors tend to think of ProShares and Direxion when the subject of leveraged ETFs is brought up, as those two sponsors provide many of the 2x and 3x leveraged products on the market.

However, leverage can also be less than 100%.  In the case of AMLP, the fund’s market value is based on 100% daily leverage while the fund’s NAV calculation (what the shareholder sees) uses 62.5% leverage and seeks to track 62.5% of the daily change of the underlying index.  This fact does not appear to be disclosed anywhere to shareholders:  not in the AMLP prospectus (pdf), not in the Statement of Additional Information (pdf), and certainly not in the marketing materials.

The fund’s custodian, Bank of New York Mellon (BNY), is responsible for the daily calculation of the NAV and has apparently been informed about the daily leverage factor it should apply to its calculations.

In my original article, I stated the “Total Expense Ratio” of 0.85% appears to be misleading since it did not account for any of the 35% corporate tax impact.  It now appears that “misleading” was much too soft of a word because the real expense ratio is closer to 0.85% plus 37.5% of the daily movement of the underlying index.  Anyone can verify this by comparing the daily change of the Alerian MLP Infrastructure Index to the daily change of AMLP.  Note: the typical daily factors for AMLP range between 59% and 66%.  I am using 62.5%, with a 37.5% reciprocal, based on information supplied in the response I received from ALPS.  Contrarily, the website states  “a tax expense of 0.00% has been assumed since it cannot be predicted whether the Fund will incur a benefit or liability in the future.”  Seems to me they think it will be 37.5% of the daily change.

After less than a month of trading, the 37.5% daily clipping has added up to $1,026,353.10 as of 9/22/10.  This figure is derived by subtracting AMLP’s net asset value (what shareholders own) of $127,764,948.39 from the $128,791,301.46 market value (value of securities held).  You can calculate the current difference using the data as listed on the performance page of the website.  The 0.8% difference also happens to equal to AMLP’s performance lag and amounts to a huge increase in the effective expense ratio.

If I were a shareholder, I would want to know where the other 37.5% of my promised gains went.  Those profits are supposedly being held back to pay AMLP’s corporate taxes.  AMLP is touting its tax efficiency while at the same time clipping shareholders 37.5% of the daily movement for tax reasons.  Now tell me again how the ETF structure is superior – especially for investors wanting to hold AMLP in an IRA like the marketing materials suggest.

As I alluded to in my original article, I don’t think the current shareholders understand what they bought, and now that misunderstanding has reached a level of $128 million.  Who is to blame for this?  I’m sure some will point their finger at the SEC saying it should not have approved this ETF.  However, if the SEC only saw the prospectus and SAI, maybe they didn’t know about the 37.5% daily clipping factor either.

Representatives from ALPS and Alerian discussed this article with me under the condition that I not quote them and not use their names.  Both confirmed the daily NAV change calculation is reduced by about 37.5% from the daily index change calculation.

ALPS and Alerian maintain that AMLP will still deliver superior long-term after-tax results when held in a taxable account.  The taxation of MLPs is a difficult subject, so perhaps that is true, but I have trouble understanding how it is possible when AMLP is taking a 37.5% daily hit up front.

Disclosure covering writer, editor, and publisher: I am not a tax advisor and I am not a lawyer, but I have read a fund prospectus or two.  All comments regarding taxes and legal issues are merely my opinions as an interested observer.  No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned – and will probably never happen after this article.

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