How To Build An MLP ETF That Does Not Lag Its Index

etfs etfsRon Rowland: ETF sponsors have demonstrated their ingenuity in many facets of the ETF industry, providing investors with easy access to a wide variety of asset classes.  These ETFs track their target indexes very closely, even after accounting for all expenses.  The primary exception is ETFs claiming to track Master Limited Partnerships (“MLPs”).  MLP ETFs have failed miserably in this respect, with products like the Alerian MLP ETF (AMLP) trailing its index by a whopping 31% (8.2% annually) as of June 30, 2013.  Below, I reveal how to build an MLP ETF that beats its index without increased risk.

Even with this miserable MLP ETF performance record, investors continue to sink billions of dollars into these funds.  Similar products, known as exchange traded notes (“ETNs”), do a much better job of tracking these same underlying indexes.  MLP ETNs typically lag their indexes by less than 1% annually, in line with their stated expense ratios.  However, ETNs carry credit risk, and their monthly distributions are not tax deferred.  This makes them an undesirable alternative for many investors.

The reason MLP ETFs underperform so drastically is because they use a C-corporation structure.  Other ETFs pay no taxes at the entity level and enjoy the pass-through status provided by the Registered Investment Company (“RIC”) structure.  MLP ETFs are subject to the 35% federal corporate income tax rate and various state income taxes at the entity level.  The C-corporation structure is required because a RIC’s portfolio cannot exceed a 25% allocation to MLPs.

Many MLP ETFs assume an effective tax rate of 37% to cover both federal and state impacts, and they must somehow account for these tax liabilities.  They accomplish this by clipping 37% off the index’s daily price change when calculating the ETF’s NAV.  If the index changes by 1.00%, the ETF’s NAV will change by only 0.63%, essentially passing the 37% tax bill to the shareholders.  Unfortunately, I have yet to see an MLP ETF sponsor explain this daily leverage to its shareholders.  Instead, they tend claim it is their secret to packaging MLPs in an ETF.

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