A fund sells some shares of an MLP today for a loss of $3. Six years from now, the fund sells shares in the same MLP for a gain of $2. The fund has a net economic loss in this particular position of $1 overall, but has recognized a taxable gain of $2 because of the timing. The fund lost the opportunity to use the $3 in losses, and now owes taxes where they might not have.
It is important to note the ETF’s net asset value (NAV). The NAV is calculated daily based on all gains or losses— whether or not realized—and deferred tax liabilities or assets. The taxes the corporation has to pay, however, come right out of the NAV as well, directly impacting performance.
Deferred Tax Liabilities and Deferred Tax Assets
To understand the performance of an MLP ETF with this corporate structure, investors should understand that the NAV of the ETF they see quoted online bakes in assets and liabilities not usually seen in an ETF, and those directly impact performance.
Unrealized gains are created inside an MLP ETF the same way they are in your own portfolio—when the value of an MLP increases but the fund has not yet sold the MLP. Unrealized losses are created when the value declines. Every single position in the ETF is by definition either in a state of unrealized gain or unrealized loss. From an accounting perspective, this means the fund always has an accrued deferred tax liability for all unrealized gains and a deferred tax asset for all unrealized losses accumulated in the fund. These deferred tax assets and liabilities represent hypothetical future tax payments and deductions, respectively, that may not be paid prior to termination of the ETF, but have real implications for the value of the fund on a daily basis nonetheless. Critically, deferred tax assets and liabilities are updated daily for the calculation of NAV—causing the fund to gain and lose value based on estimated future taxes owed.
Let’s assume each share of an MLP ETF has a claim of $100 worth of MLPs—that’s the proportional share of all the securities priced on the open market. But based on the above calculation of potential gains and losses on those MLPs, the fund will owe a theoretical $2 per share in future taxes because of an implied gain in those positions. A new investor would not pay $100 for a share of the ETF, because it wouldn’t be fair for them to pay a tax that was created during the holding period of the previous investor. The deferred tax liability keeps track of potential future taxes, allowing the new investor to purchase the fund at the correct fair value of $98. Conversely, an investor would pay a “premium” for a fund that has accumulated deferred tax assets.
For an investor used to traditional ETF or mutual fund structures, this concept is entirely alien. In those cases, there’s no concept of these future tax liabilities reducing current NAV, because the traditional ETF or fund itself will never pay any taxes—it will simply distribute any realized capital gains to shareholders, and those shareholders pay the tax.
(It’s worth noting that the correct calculation of the deferred tax asset and deferred tax liability by the ETF is a subject of contention in some circles. MLP-structured products have received lawsuits in the past when funds improperly estimated their deferred tax assets and liabilities. Swank Capital, in 2010, had to settle a lawsuit regarding its Cushing MLP Total Return Fund’s calculation of deferred tax asset.)
The existence of deferred tax assets and liabilities significantly alters the interpretation of tracking-error statistics for MLP ETFs. Because the assets and liabilities are incorporated into the fund’s NAV—but not into its underlying index— tracking-error statistics do not indicate how close the underlying MLP investments track the relevant index, but instead may reflect a rough estimate of the tax cost associated with the MLP ETF’s C-corporation structure. This “hit” to NAV may be a “tax” cost that detracts from the benefit of deferring tax on a portion of the distributions received from an MLP ETF. Similarly, premium and discount measures—which compare the share price of the ETF at the end of the day to its NAV—can be tricky.