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.