AMLP: An ETF Cautionary Tale

 ALPS Alerian MLP ETF (AMLP) has seen more than $2.5 billion of inflow in the past year. Investors are clearly clamoring for this fund, which invests in master limited partnerships, or MLPs. There are lots of reasons to like MLPs: They are a tax-advantaged, consistent source of income in a yield-starved market environment. The intention behind the fund is excellent: simplify the often complicated process of owning MLPs by applying an ETF wrapper to the broad asset class. However, AMLP is not the right vehicle for the majority of investors, and it represents one of the rare cases when buying the ETF structure makes very little sense.

Legally MLPs can make up only 25% of a portfolio registered under the Investment Company Act of 1940. Most mutual funds and ETFs are structured this way. 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. 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. As a result, AMLP has lagged its index significantly. Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%. The upside? When MLPs are down, AMLP declines less because it can reverse some of the deferred tax liabilities it has accrued. For all but the most risk-averse yet desperate-for-yield investors, this downside protection is not enough to make up for the fund's structural issues.

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  (AMJ). With more than $5 billion in assets, this exchange-traded note is the largest ETN of any kind--so large that JP Morgan stopped creating new shares in June of this year. When a fund stops creations, it tends to trade at a premium to net asset value because the creation process is what keeps exchange-traded products in alignment with their NAVs. Much of the new aggregate demand for MLPs has been shifted to AMLP in light of these changes. AMLP has also enjoyed inflows because many investors have also been (rightfully) wary of AMJ from the start. An ETN is an unsecured debt security backed by the issuer, guaranteed to give you the return of MLPs as long as the issuing bank does not file for bankruptcy. Despite the risks inherent to ETNs, when it comes to MLPs, investors are better served by the ETN wrapper than the ETF's taxation nightmare.

Fundamental View
MLPs are focused in the "midstream" energy sector, 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 product to market. They charge fees based on volume, not volatile commodity prices, so although MLPs are in the energy sector, their revenues are remarkably consistent. Infrastructure MLPs are slightly less volatile than the S&P 500 and significantly less volatile than fellow mid-cap energy equities.

The legal structure of MLPs means that most of their income is passed on to investors, but this also means that they must borrow money to finance new projects. As long as interest rates remain low, MLPs will be able to finance new projects and grow. An investment in MLPs should be motivated by the belief that U.S. energy production and worldwide energy demand will continue to grow at a healthy pace. MLPs are an appropriate investment for those speculating on the midstream energy sector or as part of a diversified income-seeking equity portfolio.

Federal regulation forces new energy projects to undergo a rigorous vetting process, so economically unviable pipelines are rarely built. This efficient use of capital ensures that most pipelines and processing facilities run by MLPs have local monopolies free of direct competition.

As natural gas production and demand rise, so do the fortunes of MLPs. Conversely, a decrease in demand is the biggest risk to the sector. The future looks bright on this count: The U.S. produces more natural gas than any other country in the world, and production grew by a healthy 7.7% last year. Worldwide natural gas consumption went up by 2.2% in 2011 despite significant consumption declines in the EU. Gains in China were particularly robust, as demand increased by 21.5%. The domestic MLPs that AMLP holds are well-placed to capitalize on further production growth.​

AMLP holds three different types of MLPs: gathering and processing, natural gas pipelines, and petroleum transportation. These three sectors of the industry operate at various stages of the transportation journey of energy. The largest MLPs own several businesses to capitalize on their scale and offer start-to-finish services.

Gathering and processing covers businesses that transport raw gas from the wellhead, process it, and move it to the cross-country pipelines. They often keep the impurities (natural gas liquids) they removed from the gas and sell them for additional revenue.

Natural gas pipelines take the processed natural gas and transport it through their extensive pipeline systems. They charge fees by volume through long-term contracts. As long as the gas keeps flowing at higher and higher volumes, pipeline MLPs will maintain good revenue growth. These MLPs can additionally protect their income stream by using a pay reservation fee structure, which means owners of natural gas buy the right to use the pipeline. Whether customers actually use the network or not, the MLP still gets paid. Natural gas pipelines are heavily regulated: The Federal Energy Regulatory Commission must approve projects, and it also sets the volumetric price MLPs can charge.

Finally, petroleum pipelines transport crude oil to the processing plants and then ship the usable products on to consumers. Usually, these liquid-transporting pipelines are allowed to adjust their charge each summer by the previous year's producer price index plus 2.65%, which offers a unique inflation hedge.

MLPs have experienced an increase in correlation with the market because of macroeconomic uncertainty: In periods of volatility, market correlation goes up across the board. During the financial crisis, MLPs suffered less than most sectors, and the increased correlation dropped off immediately toward the end of 2008.

Taxation
AMLP tracks the Alerian MLP Infrastructure Index, which is composed of 25 pipeline and processing MLPs. Owning MLPs outright creates a unique tax headache: K-1 forms must be filed in every state each MLP operates in. When an MLP pays a distribution to investors, the lion's share is treated as return of capital and is not taxed immediately. Instead, it is subtracted from the owner's cost basis. When investors sell shares, they pay the capital gains rate on the capital appreciation of the shares. They also pay ordinary income tax on the difference between the reduced tax basis and the original tax basis. Essentially, investors are able to defer paying taxes on distributions until they sell their shares. If the owner holds the MLP so long that the reduced tax basis reaches zero, any further basis reductions from distributions will be automatically taxed as a long-term capital gain. Distributions from ETN competitors are taxed immediately. Investors simply pay ordinary income tax on distributions every year.

AMLP handles all K-1s and sends investors a single 1099, which is much easier to handle. The ETF preserves the tax-deferred benefits of MLP ownership. When MLPs are held in a retirement account, they can become taxable, but owning AMLP in a retirement account circumvents these potential tax liabilities.

Now, the ugly part. Because of legislation forbidding open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. 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. 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.

Fees
AMLP charges a management fee of 0.85% annually, which is the typical going rate for exchange-traded MLP products. However, because of the tax situation discussed at length above, its actual gross expense ratio is a staggering 4.86%. After taxes, AMLP is one of the most expensive ETPs on the market.

Alternatives
There are two major MLP ETNs: AMJ, which has been discussed, and  UBS E-TRACS Alerian MLP Infrastructure ETN , which is also worth a look. If MLPI continues to attract positive inflow going forward, it could take top billing, but for now we still prefer AMJ. Like AMLP, it has some drawbacks: Because of its path-dependent fee structure, its actual expense ratio can be higher, though it should not diverge significantly from its advertised rate of 0.85%.

AMJ is closed for creations, meaning some investors might be wary of buying it at a premium. Immediately after the closure was announced, premiums as high as 3% did open up, but since then the note has consistently traded at a slight discount. Investors purchasing AMJ just need to make sure that the fund is still trading near its net asset value. 

 

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