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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 (NYSEARCA: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.

Rather than filing for a patent, here is my “Methodology for Building an MLP ETF That Does Not Lag Its Index”:

  1. Choose the MLP Index you wish to track (and take other steps necessary to file and launch an ETF).
  2. Create a portfolio designed to deliver 159% of the daily change of the index by owning all securities in the index and leveraging up all positions in the portfolio.
  3. Reset the leverage daily and clip the NAV by 37% of the daily change for future tax liabilities, just like other MLP ETFs do. This leaves the ETF’s NAV with just 63% of the daily leveraged move.
  4. The daily ETF NAV change should now match the underlying index (159% x 63% = 100%). Therefore, this approach should not increase the risk, as measured by standard deviation of the daily price change, over that of the underlying index.
  5. The use of leverage will increase the distributions the ETF receives by 59% over that of the underlying index. For example, if the index is yielding 6.00%, then the leveraged holdings should generate a 9.54% annual yield coming into the ETF.
  6. If the ETF has standard operating and management fees of 1%, and assumes another 1% for the borrowing costs associated with the leverage, then the net yield to ETF shareholders should still be in the range of 7.5%, well above the 6.0% yield of underlying index.
  7. The 159% leverage and 37% effective tax liability are only estimates and do not account for potential tax deductions related to borrowing costs. The final values will likely require adjustment.
  8. Disclose to shareholders the horrendous tax burdens the ETF faces and how the ETF is managing it. In my opinion, MLP ETFs today do not fully disclose the magnitude of the tax impacts, the reasons for underperforming their benchmark by 8% annually, and their use of 0.63x leverage (but the SEC let’s them get away with it).

The net result is an MLP ETF that tracks the daily price change of its underlying index with near perfection while producing a shareholder yield exceeding the yield of the underlying index.

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

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