Why tracking errors in MLPA make the ETF underperform its index
The Global X MLP ETF (MLPA)
The Global X MLP ETF (MLPA) tracks the Solactive MLP Composite Index. In the graph below, we’ve shown how MLPA performed versus its benchmark index for year-to-date, six months, and one year.
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The benchmark index tracks the overall performance of the United States master limited partnership (or MLP) asset class. The index comprises MLPs engaged in the transportation, storage, processing, refining, marketing, exploration, production, and mining of natural resources.
The graph below shows the total returns from MLPA and its benchmark index in the past year.
The tracking error of MLPA is 3.96%. This means the standard deviation for excess average weekly returns for the benchmark index over MLPA for the past year is 3.96. 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 MLPA and its benchmark index can partly be attributed to the expense ratio. The management fee applicable to MLPA is 0.45% per annum. So the returns from MLPA will be reduced by 0.45%, while no such charges apply on the index returns since the benchmark index is a theoretical entity and isn’t traded or exchanged. So MLPA will underperform its index by the expense ratio, all other factors remaining constant.
From the table above, we find that as of April 16, 2014, MLPA and its benchmark index have the same MLP names in their top five holdings. However, the percentage weighting of the holdings was different between the two portfolios. How the sampling effect of MLPA affects its returns is shown in the table below.
The effect of sampling—the difference in the holdings between MLPA and its benchmark index—is another cause of the tracking error. For example, as of April 16, 2014, Spectra Energy Partners (SEP) constituted 5.4% of MLPA’s total portfolio, while SEP accounted for 5.1% of the portfolio of its index. Year-to-date and one-year returns for SEP are 16.4% and 44.1%, respectively. So the additional 0.3% (5.4% – 5.1%) holding of SEP by MLPA translated into 0.05% and 0.13% of excess returns for MLPA with respect to its index for year-to-date and one-year periods. Readers may note that MLPA underperformed its index by 1.5% and 3.2% for these two periods, respectively. The table shows similar calculations for the other top holdings of MLPA.
The other reason for the variation of the performance of the ETF from its benchmark index is income tax. For federal income tax purposes, MLPA has been structured as a “C-Corp.” So MLPA 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 MLPA 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.