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Why the MLPJ ETF shows tracking error versus its benchmark index

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Nov. 20 2020, Updated 1:31 p.m. ET

The Junior MLP ETF (MLPJ)

The Junior MLP ETF (MLPJ) tracks the Solactive Junior MLP Index. In the graph below, we’ve shown how MLPJ performed versus its benchmark index for year-to-date, six months, and one year.

The benchmark index is designed to track the overall performance of 30 small-cap entities that are structured as master limited partnerships and are engaged in transportation, storage, processing, holding, refining, marketing, exploration, production, and mining with a focus on natural resources. Only MLPs with a market capitalization between $250 million and $2.5 billion are included.

The graph below shows the total returns from MLPJ and its benchmark index in the past year.

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The tracking error of MLPJ is 4.38%. This means the standard deviation of excess average weekly returns for the benchmark index over MLPJ for the past year is 4.38. 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 MLPJ and its benchmark index can partly be attributed to the expense ratio. The management fee applicable to MLPJ is 0.75% per annum. So the returns from MLPJ will be reduced by 0.75%, while no such charges apply on the index returns, since the benchmark index is a theoretical entity and isn’t traded or exchanged. So MLPJ 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, MLPJ and its benchmark index have the same MLP names in their top five holdings. However, the percentage weighting of the holdings were different between the two portfolios. How the sampling effect of MLPJ affects its returns is shown in the table below.

The effect of sampling—the difference in the holdings between MLPJ and its benchmark index—is another cause of the tracking error. For example, as of April 16, 2014, Tesoro Logistics LP (TLLP) constituted 7.6% of MLPJ’s total portfolio, while TLLP accounted for ~6.7% of the portfolio of its index. Year-to-date and one-year returns for TLLP are 20.4% and 22.2%, respectively. So the additional 0.9% (7.6% – 6.7%) holding of TLLP by MLPJ translates into 0.2% and 0.2% of excess returns for MLPJ with respect to its index for year-to-date and one-year periods. Readers may note that MLPJ underperformed its index by 1.9% and 6.1% for the year-to-date and past-six-month periods, respectively. The table shows similar calculations for the other top holdings of MLPJ.

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

To learn more about important considerations that effect MLP investments, check out Market Realist’s Master Limited Partnerships page.

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