Beware of MLPs in ETF Wrappers: AMLP

August 27, 2010 by  
Filed under Commentary, ETF IPOs (New ETFs), ETFs

Note:  Please also read the ALPS response to this article.

Many investors have been looking forward to the day when they could buy an exchange-traded fund (ETF) containing a basket of Master Limited Partnerships (MLPs).  I am not one of them.  Although I generally prefer ETFs over ETNs (exchange-traded notes), that is not the case when the investments being targeted are MLPs.

Earlier this week (on 8/25/10), the Alerian MLP ETF (AMLP) was launched.  It is the first MLP ETF product joining a lineup of five existing MLP ETNs.  I also believe it is the first ETF of any kind that is virtually guaranteed to underperform its chief competitor.

Corporate Taxes

Before buying AMLP you need to ask yourself why all the other sponsors chose an ETN package over an ETF wrapper.  The answer is taxation.  As noted in the prospectus:

AMLP is taxed as a regular corporation for federal income tax purposes and as such is obligated to pay federal and applicable state and foreign corporate taxes on its taxable income. This differs from most investment companies, which elect to be treated as “regulated investment companies” under the tax code in order to avoid paying entity level income taxes. Under current law, AMLP is not eligible to elect treatment as a regulated investment company due to its investments primarily in MLPs invested in energy assets. As a result, AMLP will be obligated to pay federal and state taxes on its taxable income as opposed to most other investment companies which are not so obligated.

In order to achieve “ETF status” AMLP had to give up its “pass through status” and be taxed as a corporation. AMLP will generally compute deferred income taxes based on the federal income tax rate applicable to corporations, currently 35%, and an assumed rate attributable to state taxes. Therefore, AMLP is required to make the following disclosure in its prospectus:

Potential Substantial After-Tax Tracking Error From Index Performance. As discussed above, AMLP will be subject to taxation on its taxable income. The NAV will also be reduced by the accrual of any deferred tax liabilities. The underlying index however is calculated without any deductions for taxes. As a result, AMLP’s after tax performance could differ significantly from the Alerian MLP Infrastructure Index even if the pretax performance is closely correlated.

Neither the AMLP prospectus(pdf) nor the Statement of Additional Information(pdf) provide estimates or examples of how significant an impact the corporate taxation will have on performance.  It is also not clear to me which state taxes will apply: the MLP’s state or the corporation’s (AMLP) state.  Don’t forget, this is taxation that occurs at the ETF level before an individual shareholder’s federal and state taxes are taken into account.

About the Fund

The Alerian MLP ETF (AMLP) from ALPS seeks investment results (before fees, expenses, and taxes) that generally correspond to the price and yield performance of the Alerian MLP Infrastructure Index.  The underlying index is comprised of 25 midstream energy Master Limited Partnerships and provides investors with an unbiased benchmark for the infrastructure component of this emerging asset class. The index is calculated using a capped, float-adjusted, capitalization-weighted methodology that results in greater diversification.

Additional information can be found on the AMLP home page, the fact sheet(pdf), and the complete list of holdings.  The claimed “Total Expense Ratio” of 0.85% appears to be misleading as it does not account for any of AMLP’s corporate taxes.

It would appear that AMLP is a roaring success, averaging more than one million shares a day for its first two days on the market.  I haven’t seen an AUM (assets under management) report, but I wouldn’t be surprised to see assets north of $20 million already.  My guess is that all the trading and assets are from shareholders that did not read the prospectus and are in for a big surprise.

AMLP vs. MLPI

UBS E-TRACS Alerian MLP Infrastructure Index ETN (MLPI) tracks the same index as AMLP with the same identical 0.85% expense ratio.  However, there will be one huge difference in their performance:  AMLP will be taxed as a corporation and the NAV will reflect a 35% withholding for taxes while MLPI will not.

For my money, MLPI is the clear choice over AMLP.  Taxation of MLPs is a difficult subject, and I do not claim to know all the ins and outs.  I am not a tax advisor, but I cannot envision a profitable situation where AMLP’s corporate taxes will be negative.  Therefore, a potentially “risk-free” arbitrage trade could be to go long MLPI while shorting AMLP – it’s just like being the tax man.

Disclosure covering writer, editor, and publisher: I am not a tax advisor.  I am not a lawyer.  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.

Comments

4 Responses to “Beware of MLPs in ETF Wrappers: AMLP”

  1. cmguss on August 27th, 2010 7:43 pm

    Apparently MLPI either does not truly track the AMZ or it does so at a tax penalty per the second quoted paragraph below.

    The following quoted from http://www.indexuniverse.com/sections/news/7989-alps-debuts-mlp-etf.html.

    Unlike ETNs, the Alerian MLP ETF (NYSEArca: AMLP) will come with no credit risk. The value of an ETN is based solely on the good faith and credit of the issuing bank, whereas ETF owners hold a share in the underlying assets of the fund.

    Alerian also says that the ETF will retain the tax benefits of MLP distributions. MLPs are typically a nightmare to hold in a fund setting, because funds are typically taxed as registered investment companies, or RICs, which may only invest 25 percent of their assets in MLPs or they become subject to various tax penalties. AMLP has elected to be taxed as a corporation, which helps it get around this 25 percent tax [issue].

    “The Alerian MLP ETF provides a single Form 1099, no K-1s, and allows investors to potentially benefit from return of capital and qualified dividend tax treatment of distributions,” Alerian president and CEO Kenny Feng said in a release.

  2. cmguss on August 27th, 2010 7:54 pm

    Mistake above. Should have stated an ETF (not MLPI) as a RIC, as opposed to a corporation, would not be able to track the AMZ properly without tax penalties.

    I suppose the question then is, even though ETNs are generally treated as prepaid contracts, how is the MLPI dividend taxed in comparison or how do taxes affect the pass-through of dividends of the note holder?

  3. Ron Rowland on August 28th, 2010 9:25 am

    cmguss,

    In response to your first point that AMLP will not correctly track the AMZI index, you are correct and that is clearly stated in the original article and in the AMLP prospectus with the following warning:

    “Potential Substantial After-Tax Tracking Error From Index Performance. As discussed above, AMLP will be subject to taxation on its taxable income. The NAV will also be reduced by the accrual of any deferred tax liabilities. The underlying index however is calculated without any deductions for taxes. As a result, AMLP’s after tax performance could differ significantly from the Alerian MLP Infrastructure Index even if the pretax performance is closely correlated.”

    Additionally, the other point you quoted “AMLP has elected to be taxed as a corporation, which helps it get around this 25 percent tax [issue].” is exactly the main point of my article. AMLP will be taxed as a corporation – not a pass through entity. In other words, in order to allow AMLP to have more than 25% of its assets in MLPs it has elected to pay corporate taxes.

    Regarding ETNs such as MLPI: ETNs do not invest in the MLPs and therefore I believe any MLP tax treatment is a moot point when discussing ETNs. I have assumed that all distributions from an ETN are taxable, but then I hold them in an IRA so it doesn’t really matter to me. I suppose it is possible that an ETN could declare part of its distrubution a “return of capital” but I do not believe that any of the current ones are doing so.

  4. AMLP’s Dirty Little Secret | Invest With An Edge on September 24th, 2010 2:02 am

    [...] 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 [...]

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