By Abby Woodham
ALPS Alerian MLP ETF(
) 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
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
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(
) . 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
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
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
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.
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.
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.
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.
Morningstar, Inc. licenses its indexes to institutions for a
variety of reasons, including the creation of investment products
and the benchmarking of existing products. When licensing indexes
for the creation or benchmarking of investment products,
Morningstar receives fees that are mainly based on fund assets
under management. As of Sept. 30, 2012, AlphaPro Management,
BlackRock Asset Management, First Asset, First Trust, Invesco,
Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or
more Morningstar indexes for this purpose. These investment
products are not sponsored, issued, marketed, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in any investment product based on or
benchmarked against a Morningstar index.
It's Time To Lift Restrictions On U.S. Oil