ALPS Plans “Plus” Version Of MLP ETF

by on May 8, 2011 | ETFs Mentioned:

Since its inception in August 2010 the Alerian MLP ETF (AMLP) has attracted more than $1 billion in assets, reflecting the tremendous amount of investor interest in achieving exposure to this corner of the domestic energy market through the exchange-traded structure. ALPS is now laying the groundwork for another version of the popular fund that would seek to minimize tracking error that occurs as a result of the unique product structure. A recent SEC filing detailed plans for the Alerian Plus MLP Infrastructure ETF, which would seek to replicate the same benchmark to which the existing AMLP is linked.

Because more than a quarter of AMLP’s portfolio consists of securities that qualify as MLPs, the fund isn’t eligible to be treated as a regulated investment company under the Internal Revenue Code of 1986, and is instead taxed as a regular corporation for federal tax purposes. That means that AMLP will generally accrue a deferred tax liability when the underlying securities appreciate and a deferred tax asset when the MLP holdings lose value. Either scenario results in tracking error–a discrepancy between fund performance and the return of the related index [MLP Exposure: ETFs Or ETN?].

Since launching, AMLP has performed quite well thanks to a nice run-up in the price of MLPs. But that has also resulted in material tracking error for the fund. Through April, AMLP had gained about 14.9% since inception, while the underlying Alerian MLP Infrastructure Index had increased by close to 24.2%–even though AMLP’s portfolio replicates the benchmark almost perfectly. The gap is a result of the tax treatment of AMLP, as the benchmark is calculated without any consideration to taxes an investor may incur [MLP ETFs: Fact And Fiction].

The proposed “plus” version of the MLP ETF will seek to minimize this tracking error by borrowing money from a bank and investing the proceeds in component securities of the related index. According to the filing, the fund would borrow the maximum amount permitted under the Investment Company Act of 1940–currently up to one third of total assets. That strategy would increase the volatility of the fund, on both the upside and the downside. While the tax nuances of AMLP have created a return drag as the underlying securities have appreciated, it should also be noted that the creation of a deferred tax asset can limit downside losses in bear markets [When ETNs Are Better Than ETFs].

Natural Gas MLP ETF

In the same filing, ALPS also detailed plans for an Alerian Natural Gas MLP ETF. That fund would seek to replicate the Alerian Natural Gas MLP Index, an equal-weighted benchmark that consists of MLPs that earn a majority of their cash flow from the transportation, storage, and processing of natural gas and natural gas liquids. This product would also be structured as an ETF, meaning that it faces the same tax issues as AMLP. According to the filing, ALPS would utilize a strategy similar to its “plus” version of the broader MLP ETF, borrowing money from a financial institution and using the proceeds to invest in securities that make up the underlying index [see Q&A with Alerian CEO Kenny Feng].

UBS currently offers an exchange-traded note (ETN) linked to the performance of the Alerian Natural Gas MLP Index; MLPG offers a way to access that asset class that sidesteps the tax issues associated with MLP ETFs. Because ETNs do not actually hold the underlying securities–they’re debt instruments whose returns are linked to an index–this structure eliminates tracking error. The relative benefits and drawbacks of achieving MLP exposure through various exchange-traded products is a complex issue impacted by a number of factors, including performance, distribution yield, and the tax status of each individual investor [see More Thoughts On MLP ETFs/ETNs].

No expense ratios were disclosed for either of the proposed ETFs. AMLP charges 0.85%, the average for the funds in theĀ MLPs ETFdb Category.

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Disclosure: No positions at time of writing, photo is courtesy of Luca Galuzzi.