An investor's must-know guide to tracking error for MLP ETFs (Part 2 of 6)
AMLP and AMZI
The Alerian MLP Exchange Traded Fund (AMLP) is an ETF that tracks the Alerian MLP Infrastructure Index (AMZI). In the graph below, we’ve shown how AMLP performed versus its benchmark index, AMZI, for year-to-date, six months, and one year.
AMZI is a float-adjusted, capitalization-weighted composite of 25 energy infrastructure master limited partnerships (or MLPs). These MLPs earn the majority of their cash flow from the transportation, storage, and processing of energy commodities.
The graph below shows the total returns from AMLP and AMZI in the past year.
The tracking error of AMLP is 4.14%. This means the standard deviation of the excess average weekly returns for the benchmark index over AMLP for the past year is 4.14. Please note that the higher the tracking error, the higher the volatility of daily excess returns of the asset, or the ETF, in this case.
The divergence or volatility in returns between AMLP and its benchmark index can partly be attributed to the expense ratio. The management fee applicable to AMLP is 0.85% per annum. So the effective returns from AMLP will be reduced by 0.85%, while no such charges are applicable on the index returns, since the benchmark index is a theoretical entity and isn’t traded or exchanged. So AMLP would underperform its index by the expense ratio, all other factors remaining constant.
The other reason for the variation of the performance of the ETF from its benchmark index is due to income tax. For federal income tax purposes, AMLP has been structured as a “C-Corp.” So AMLP accrues deferred tax liability for its future tax liability on the capital appreciation of its investments, and the distributions it receives on equity securities of MLPs are considered a return of capital. The deferred income tax expense (or benefit) represents an estimate of AMLP’s potential tax expense (or benefit) if it were to recognize the unrealized gains (or losses) in the portfolio. All realized and unrealized gains (or losses) on investments and expenses may vary greatly from year to year and from day to day, depending on the nature of the fund’s investments, the performance of those investments, and general market conditions.
From the table above, we find that as of April 16, 2014, AMLP and its benchmark index have the same MLP names in their portfolios. However, the percent weightage of the holdings vary between the two portfolios. How the sampling effect of AMLP affect its returns is shown in the table below.
The effect of sampling—the difference in the holdings between AMLP and its benchmark index, AMZI—is another cause of tracking error. For example, as of April 16, 2014, Enterprise Products Partners LP (EPD) constituted 9.9% of AMLP’s total portfolio, while EPD accounted for 9.8% of AMZI’s portfolio. Year-to-date and one-year returns for EPD are 10.3% and 26.6%, respectively. So the additional 0.1% (9.9% – 9.8%) holding of EPD by AMLP translated into 0.1% and 0.03% of excess returns with respect to its index, AMZI, for year-to-date and one-year periods. Readers may note that AMLP underperformed AMZI by 1.1% and 4.9% for these two periods, respectively. The table shows similar calculations for the other top holdings of AMLP.
The largest MLP ETF fund is the Alerian MLP ETF (AMLP), which tracks the Alerian MLP Index, AMZI, a capitalization-weighted composite of 25 energy infrastructure companies. Other MLP ETFs include the Yorkville High Income MLP (YMLP), the Global X MLP ETF (MLPA), the Yorkville High Income Infrastructure MLP ETF (YMLI), and the Global X MLP & Infrastructure ETF (MLPX). Note that these other MLP ETFs have significantly smaller market caps than AMLP.
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