An investor's must-know guide to tracking error for MLP ETFs

Part 3
An investor's must-know guide to tracking error for MLP ETFs (Part 3 of 6)

How closely does YMLP track the Solactive High Income MLP Index?

The Yorkville High Income MLP

The Yorkville High Income MLP (YMLP) ETF is an exchange-traded fund that tracks an index called the Solactive High Income MLP Index. In the graph below, we’ve shown how YMLP performed versus its benchmark index for year-to-date, six months, and one year.

YMLP Returns vs IndexEnlarge Graph

The benchmark index consists of the MLPs involved in oil exploration and production, natural gas exploration and production, the sale, distribution, and retail marketing of propane and other natural gas liquids, crude oil shipping, dry bulk shipping, refined products transportation, liquefied natural gas shipping, and other marine transportation. The index also tracks companies that engage in direct mining, production, and marketing of natural resources, including timber, fertilizers, coal and other minerals, and royalty trusts. The graph below shows the total returns from YMLP and its benchmark index in the past year.

YMLP 1 Year ReturnsEnlarge Graph

The tracking error of YMLP is 3.88%. This means the standard deviation of excess average weekly returns for the benchmark index over YMLP for the past year is 3.88. 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 YMLP and its benchmark index can partly be attributed to the expense ratio. The management fee applicable to YMLP is 0.82% per annum. So the effective returns from AMLP will be reduced by 0.82%, 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 YMLP would underperform its index by the expense ratio, all other factors remaining constant.

YMLP HoldingsEnlarge Graph

From the table above, we find that as of April 16, 2014, YMLP and its benchmark index don’t have the same MLP names in their top five holdings. Also, the percentage weighting of the holdings was different between the two portfolios. How the sampling effect of YMLP affects its returns is shown in the table below.

YMLPEnlarge Graph

The effect of sampling—the difference in holdings between YMLP and its benchmark index—is another cause of the tracking error. For example, as of April 16, 2014, Ferrellgas Partners LP (FGP) constituted 4.9% of YMLP’s total portfolio, while FGP accounted for 5.1% of the portfolio of its index. Year-to-date and one-year returns for FGP are 4.5% and 14.7%, respectively. So the additional 0.2% (5.1% – 4.9%) holding of FGP by the index translated into 0.01% and 0.03% of excess returns for the index with respect to YMLP for year-to-date and one-year periods. Readers may note that YMLP outperformed its index by 1.3% and 5.5% for these two periods, respectively. The table shows similar calculations for the other top holdings of YMLP.

The other reason for the variation of the performance of the ETF from its benchmark index is income tax. For federal income tax purposes, YMLP has been structured as a “C-Corp.” So YMLP 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 YMLP 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.

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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