Currently, the most popular MLP ETN is the JPMorgan Alerian MLP Index ETN (AMJ). Investors in this fund are subject to the risk of a J.P. Morgan default. One-year CDS rates can be volatile. If we look at the one- and five-year CDS rates on J.P. Morgan, we can see the likelihood of default on its debt spiked in the fall of 2011.
Clearly, the risk of J.P. Morgan’s default has normalized in the view of the market, and its CDS rates have fallen accordingly. Still, credit risk is real, and it is unique to the ETN structure. Any risk of default should be viewed as an embedded cost of the ETN, and CDS rates of the issuer’s debt are generally the best way to measure it.
COMPARING THE STRUCTURES
The difficulty in comparing the two available structures for ETP MLP exposure comes from setting an appropriate framework for analysis. In general, most investors care about their after-tax returns. However, traditionally, securities analysis is done on a pretax basis. If one were to compare, for instance, three traditional ETFs covering the U.S. stock market, taxes likely wouldn’t be a major consideration.
With MLPs, however, taxes are incredibly important, because the very reason many investors seek them out is for preferential tax treatment. And in this case, since neither structure can fully replicate direct MLP ownership, the two structures have dramatically different tax approaches.
On the one hand, MLP ETFs are taxed mostly at the corporate level and then again at the shareholder level. All income distributed to investors has already been taxed, and distributed earnings will be taxed again in the hands of the shareholders. The fund accumulates a deferred tax liability for the amount of unrealized gains it currently holds, which is adjusted into NAV. As mentioned, this often results in the deferred tax liability and taxes paid by the fund being incorrectly considered as traditional tracking error. By comparison, the MLP ETN does not have these inherent tax issues—it simply accumulated capital gains and pays coupons, like any bond subject to special tax risks associated with synthetic exposure to MLPs.
To run a fair comparison of the two and engage in accurate tracking analysis, both funds would have to be converted to either a pre- or after-tax basis. To convert to a pretax basis, you would need to know the daily deferred tax liability/asset. This is virtually impossible without the fund company providing daily data, and such data is currently only published twice a year, in the annual and semiannual report. Converting to an after-tax rate is the theoretically correct route for a fair analysis, but it involves too many leaps of faith, including an assumption of an individual investor’s tax rate, which, given the recent “fiscal cliff” compromise, is more complex than it has been in many decades.