ETFs that invest in master limited partnerships have been popular with investors looking for a reliable income stream and some diversification for an equity portfolio.
However, investment researcher Morningstar was out Friday with a warning on one the category’s most popular funds, ALPS Alerian MLP ETF (NYSEArca: AMLP), which holds $4.3 billion in total net assets. The ETF has gathered more than $2.5 billion of inflows the past year.
Morningstar’s caution flag is related to a complicated tax issue associated with MLPs, which are companies involved with the storage and transportation of commodities such as oil or natural gas.
The Investment Company Act of 1940 forbids open-end mutual funds from having more than 25% of their portfolio in MLPs.
“To get around this issue, AMLP is actually structured as a corporation that pays income tax: Before return is passed on to the investor, it must be taxed at the corporate level,” says Morningstar analyst Abby Woodham. “Although AMLP’s prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is almost 5% as of September.”
AMLP’s prospectus discloses that the ETF’s structure as a “C” corporation means the fund accrues deferred tax liability associated with the capital appreciation of its MLP investments and distributions. The ETF’s accrued deferred tax liability is reflected each day in the fund’s net asset value.
As of Nov. 8, AMLP’s total deferred tax liability was about $160.2 million, according to the ETF’s website.
As a result of the tax liability, the fund has lagged its index significantly, Morningstar’s Woodham writes in a commentary. “Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%,” she notes.
“So, why is AMLP seeing such impressive inflows despite its flaws? It’s likely because the market has been scared away from AMLP’s massive competitor, JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ),” Woodham said.
Earlier this year, JP Morgan (NYSE: JPM) halted the creation of new shares in AMJ after the exchange traded fund note hit internal size limits. Halting creations means the the ETN’s share price can deviate from net asset value. In other words, it can trade at a premium or discount, like a closed-end fund. AMJ currently holds more than $5 billion in assets. [MLP ETN Hits Size Limit]
Investors in AMLP receive a 1099 form every year. “Any taxable income from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio’s shares they must also pay up at the corporate level,” Woodham explains. “AMLP accounts for these tax liabilities in the NAV, meaning that the total return of the fund can and does trail the index by massive amounts.”
Other exchange traded products for master limited partnerships include:
- Exchange Traded Concepts Yorkville High Income MLP ETF (NYSEArca: YMLP)
- First Trust North American Energy Infrastructure Fund (NYSEArca: EMLP)
- Global X MLP ETF (NYSEArca: MLPA)
- Credit Suisse Cushing 30 MLP Index ETN (NYSEArca: MLPN)
- Morgan Stanley Cushing MLP High Income Index ETN (NYSEArca: MLPY)
- UBS E-TRACS Alerian MLP Infrastructure Index (NYSEArca: MLPI)
- UBS E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index (NYSEArca: MLPL)
- UBS E-TRACS Wells Fargo MLP Index (NYSEArca: MLPW)
- UBS E-TRACS Alerian Natural Gas MLP Index (NYSEArca: MLPG)
ALPS Alerian MLP ETF