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A Premium Reappears for JPMorgan Alerian MLP Index ETN

While investors have flocked to an MLP exchange-traded fund, we recommend sticking with exchange-traded notes for this asset class.

Morningstar Analysts, 05/10/2013

Starting in late March, JPMorgan Alerian MLP Index ETN AMJ began trading at a small premium to its net asset value. This week, the premium reached as high as 5% on below-average trading volume. The situation should not come as a surprise-- J.P. Morgan Chase JPM capped the creation of new AMJ shares in June 2012, and this decision effectively turned the exchange-traded note into a closed-end product. If demand for AMJ exceeds the shares available, the ETN will trade at a premium to NAV.

As a refresher, when the demand for shares of an exchange-traded fund exceeds the supply on offer, an authorized participant (AP) ordinarily steps in to create new shares. The AP buys the ETF's constituents and delivers them to the ETF's issuer in exchange for shares of the ETF. The opposite process, called a redemption, is when the AP delivers ETF shares in exchange for the underlying stocks. This arbitrage process prevents the price of an ETF from significantly deviating from its NAV. Because ETNs are debt obligations and do not actually own any underlying assets, the creation and redemption process occurs with cash. However, AMJ currently has no creation capability.

It is likely that JPMorgan decided stop creating new AMJ notes because its hedging costs grew too large. As an ETN increases in size, so do its hedging costs, and at almost $6 billion in assets, AMJ is the largest ETN on the market by a wide margin. AMJ still allows redemptions, so a major discount on the scale of this week's premium would be unlikely to occur. However, without a creation process in place, a premium will open up if demand exceeds supply, and this occurred immediately following the announcement of the cap last year. But by mid-July, AMJ began to trade close to its NAV as other master-limited-partnership products helped absorb the strong demand. However, demand and supply for AMJ are apparently out of balance again, which resulted in its steadily increasing premium earlier this week. Current holders of AMJ do not need to be concerned, and they can actually benefit (before taxes) by selling out of AMJ at a premium and purchasing a similar product. New investors, on the other hand, should be wary of AMJ. The premium can dissipate or return at any time.

Demand for AMJ remains high because the search for yield makes MLPs attractive to a growing number of investors. The five largest MLP exchange-traded products drew in an estimated $4 billion during the past year. MLPs are focused on "midstream" energy, meaning the processing and transportation of energy commodities. These companies own and operate the pipelines that deliver gas and liquids across the country, as well as the storage facilities and processing plants that bring the product to market. MLPs must pass through at least 90% of their income, which juices their yield and makes them a popular choice for income.

Instead of buying AMJ at a premium, investors should consider some of the other options available. Investors can purchase a handful of large-cap MLPs directly to enjoy the preferential tax treatment of an MLP investment, but these shareholders must file K-1s during tax season, which can be a headache that multiplies with each individual MLP owned. Alternatively, investors can consider the other MLP exchange-traded products, which generate a 1099.

During the last year, investors have been flocking to one fund in particular: ALPS Alerian MLP ETF AMLP, which is now the largest MLP product at $6 billion in assets. Investors seem to prefer this product over the MLP ETNs because ETNs carry credit risks and other complications. However, AMLP is extremely expensive and has lagged its index by almost 8 percentage points annualized since its Aug. 25, 2010, inception  through the end of April 2013. This abysmal tracking stems from regulations that prevent open-end funds from holding more than 25% of their assets in MLPs. To get around this restriction, AMLP is structured as a corporation and pays income tax, so any eligible income from the underlying MLPs must go through a round of taxation at the fund level. AMLP accounts for these tax liabilities in the net asset value, so although AMLP's prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is closer to 5.00%. The only benefit to this arrangement is some potential downside protection, as some losses can be written off using deferred tax assets.

In light of MLP ETFs' flaws, investors are left with the less-imperfect ETNs. The main drawback to ETNs is that their holders do not participate in the beneficial tax payment schedule of MLP distributions. When an MLP pays out a distribution to investors, the lion's share is treated as return of capital and is not taxed until the shares are sold. Because ETNs do not have assets, MLP ETNs do not pass this tax deferral on to holders. Owners of MLP ETNs simply pay ordinary income tax rates on distributions and capital gains rates upon the sale of shares.

The closest substitute for AMJ is UBS E-TRACS Alerian MLP Index ETN AMU, which tracks the same index. AMU's 0.80% expense ratio undercuts all of its competitors, which charge 0.85% or more. AMU was launched a month after AMJ's cap was announced, but it has struggled to attract significant assets and trades on very low volume.

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