etf’s


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This essay will explain why they might want to do that—and how you can get income from MLPs without paying corporate tax.

Energy MLPs, which account for the bulk of the MLP sector, handle hydrocarbons, using pipelines, storage tanks, fractionation plants or railcars. Enterprise Products Partners (EPD), a classic of the genre, owns all those things.

MLPs are boring but they pay fat dividends. EPD’s yield is 6.7%. Buckeye Partners (BPL) hands out 11.4%; Magellan Midstream Partners, 5.8%. Sheltered by pipeline depreciation, dividends tend to be tax-free in the early years of an investment. A fund containing many MLPs would be a terrific way to get diversification combined with a nice income stream.

Except for a little problem. A peculiarity of the tax code is that a fund’s tax exemption is snatched away if the fund puts more than 25% of its assets in partnerships. So if you want your fund to be a pure play on MLPs, the fund must lose a chunk of your profits to taxes. That’s why the Alerian fund’s average annual return since it opened its doors in August 2010 has been only 1.7%, while the MLP index it follows has delivered 4.2%.

The simple way for an energy fund to duck the corporate tax is to broaden its portfolio. It can blend a 25% allocation to MLPs with a 75% allocation to other energy companies, taking advantage of the fact that many pipeliners, like Targa Resources, Oneok and Williams, are organized as corporations rather than partnerships.

But the tax-light funds are outsold by the taxable ones. Why is that? Is it that investors want a concentrated dose of high-octane MLPs and won’t tolerate the blending fuels? Is it perhaps that they don’t understand the weird accounting? Read the explanation of the tax expense in Alerian’s financials and you will be ready to check yourself into an insane asylum.

Whatever the reason, the fact that Alerian and other taxable MLP funds are big sellers is a source of unending frustration to Simon Lack of SL Advisors, a manager of energy portfolios. Lack runs two 25/75 funds that have, between them, a mere $157 million of assets. “People are invested in AMLP even though their performance is only 50% of the index return,” Lack complains.

Jeremy Held, director of research at Alps, the firm that operates the Alerian fund, insists that his fund’s buyers know what they’re doing. They want diversified exposure to the MLP sector and they don’t want to tangle with the pile of K-1 tax forms they’d get if they owned partnerships directly. Held says that it’s not just small investors who opt for the fund. He has seen buyers with seven-figure stakes.

Like Lack’s 25/75 funds, the Alerian MLP ETF gives investors a 1099 dividend report instead of a K-1. That cuts their tax preparation bills, and it also enables them to put energy infrastructure in a tax-deferred account like an IRA. (Direct ownership of partnerships in an IRA creates chaos.)

How much do you sacrifice when you use a fund organized like the Alerian ETF?

To illustrate, we’ll start with a hypothetical MLP trading at $10 a share and paying a $1 annual dividend. Depreciation, we’ll assume, is more than enough to shelter the dividend (this is typical), so that the entire payout is considered a “return of capital,” not immediately taxable.

If you own the share directly you pocket the $1 without owing any tax for now. Your $10 cost gets adjusted down to $9. That will boost your taxable gain when you do sell. But if you have your wits you never sell.

Now suppose the share is held in a taxable MLP fund. For simplicity we will assume that the fund has no management fee.

The fund, too, will enjoy $1 of income not immediately taxable. But it must allow for the possibility that the MLP share will be sold tomorrow. If the fund did have to sell the MLP to meet redemption orders, it would owe corporate income tax on a $1 gain. The federal tax rate is 21%; state taxes add another 2 points or so. That means the fund has to set aside 23 cents for future corporate tax.

The fund may choose to disburse the entire $1 of income to fund shareholders (again, typical), in which case the fund’s books will show an asset of $10 (the MLP share) and a liability of 23 cents (potential income tax). The fund’s reported net asset value will be $9.77. Someone holding the fund will see, on his brokerage statement, a 7.7% return; had he held the MLP directly he would have seen a 10% return.

What if the MLP share appreciates? Let’s assume no dividend, simply a bull market that sends the MLP up 10% to $11. Again, a fund that pays corporate tax has to allow for 23 cents of deferred tax liability. If the fund did sell its MLP it would owe income tax on the $1 gain, and at the usual corporate rate, since corporations get no break on long-term capital gains.

Allowing for the potential future tax, the fund holding the appreciated MLP will report an NAV of $10.77, for a total return of 7.7%. The buy-and-hold direct buyer of the MLP share would be up 10%.

MLP funds

Here you see the gap between index returns and fund returns that Simon Lack is complaining about. (Note: For 2018 and later years the gap will be smaller because of the Trump tax cut.) The gap is at first only on paper; the diminished NAV doesn’t damage the $1 of income coming from the MLP. But on eventual liquidation those years of corporate tax will be felt in a shriveled sale price for the fund.

What if there’s a bear market? Since the tax-burdened fund delivers only 77% of the return going up, can it limit your damage to 77% on the way down? That depends on the sequence of events.

If the MLP share goes from $10 to $11 and then back to $10 the fund investor will be cushioned on the way down, as the NAV falls only 77 cents, from $10.77 to its starting point. In general, funds that have delivered years of positive returns wind up with a deferred tax liability, and if losses then ensue those losses will be cushioned as the tax liability shrinks.

But funds that have piled up losses are usually left with no cushion against further declines. Picture a fund whose assets sink from a starting value of $10 a share to $9. That fund has a deferred tax asset worth, in some theoretical sense, 23 cents a share, because it’s in a position to earn $1 a share without owing tax on that gain. But it would be very hazardous for the fund to report its net asset value as $9.23. Departing fund investors could walk out the door with $9.23 of cash, leaving behind meager hard assets and a pile of tax loss carryforwards that never get used.

In such a fix most funds display a deferred tax asset of 23 cents and then, in the very next line, erase it with a “valuation allowance” of minus 23 cents. The tax situation is visible but doesn’t alter the NAV, which will be just the $9 value of the portfolio.

Funds with deferred tax assets that are duly erased should be appealing to a bullish investor. You don’t pay anything for the tax shield and so you can enjoy, at least for a while, 100% of the return on the portfolio. You are also exposed to 100% of the losses. Once the fund climbs into the black (in cumulative total return), it starts showing a deferred tax liability and you start getting 77% of the upside and 77% of the down.

So far we have described what happens to investors who hang on indefinitely. What happens to investors who sell?

Take the case of an MLP that climbs from $10 to $15 over a period of years while paying a cumulative $6 in return-of-capital dividends. On sale, the direct holder will have a $5 long-term gain plus something like $6 in what I call boomerang income. (The concept is explained in 2018 Tax Guide to MLPs.)

Including Obamacare at 3.8%, the maximum federal tax on the long gain will be $1.19. The boomerang is taxed at ordinary-income rates but benefits from the recently enacted 20% deduction on pass-through business income; Obama arrives again, with no mercy from the new deduction. Maximum boomerang tax = $6 x (0.038 + 0.8 x 0.37) = $2. Net realization from the sale: $11.81.

Now put the MLP inside a taxable fund. The fund will be accruing corporate tax liability all along. Since corporations don’t get the 20% pass-through deduction the ending NAV will be $15 – 0.23 x $11 = $12.47. The investor will have a cost basis of $4 ($10 purchase price of the fund, minus dividends). Tax on the $8.47 of long gain would be $2.02, for a net realization of $10.45.

Advantage: direct ownership.

As noted, you’d be a fool to sell an MLP, unless, perhaps, it’s such a disaster that the capital loss deduction is worth more than what the boomerang will cost you. Moreover, the advantage of holding directly grows over time. Bear in mind that unrealized appreciation (on either MLPs or MLP funds) becomes tax-free on your death, and so does boomerang income.

The accounting laid out so far in this story assumes high depreciation deductions. That pretty well describes the world we are living in. But the day will come when those write-offs peter out. What would happen if the entire $1 distribution from an MLP were taxed as ordinary business income?

The taxable fund would have 77 cents left, which would come to you as a qualified dividend. After maximum federal taxes you’d have 59 cents to spend on yacht fuel. If you owned the MLP directly you’d benefit from the pass-through deduction and would owe 33 cents, for a net of 67 cents.

There would be a transition period between the point when most of the profits in the system are a return of capital to the point where most are ordinary business income. During that transition the corporate-taxed fund would have one advantage, says Robert Velotta, an MLP expert at Cohen & Co. in Cleveland: the ability to marry an operating loss from one MLP to the operating income from another. Direct holders have to keep their MLPs, and their loss carryforwards, in separate silos.

But as a direct holder you have something else going for you. Once you’ve recovered your purchase price in cumulative dividends, further dividends can give rise to a blessed pairing of ordinary deductions (suspended losses from earlier years, now usable against salaries and interest) with capital gains (taxed at low rates, or, if you have a loss carryforward from your General Electric shares, not taxed). Explanation. With a fund in the middle you can’t do that.

In tax burdens the 25/75 funds fall midway between direct ownership and ownership via an Alerian-style fund. They don’t pay corporate tax. They can pass through return-of-capital money, but they can’t pass through losses.

Add it up. For investors who are equipped to deal with K-1s, the tax laws powerfully favor direct ownership.

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The revolution was not, in fact, televised.  A simple press release filled the bill instead. This morning, BlackRock released its ETF Pulse Survey, a look at the pace of exchange traded fund adaptation across different demographics.  The survey of individual investors found that only 27% of baby boomers (aged 52 to 70) own ETFs, compared to 42% of millennials (21 to 35) and 37% of “silvers” (aged 71 or older). Martin Small, head of BlackRock’s iShares unit in the U.S., surmised that boomers: “May still be holding onto a stock-picking mentality. They may not realize that ETFs are as easy to trade as stocks and available in virtually every market segment imaginable. As a result, many pre-retirees and investors in their early years of retirement may be overlooking the ETF revolution.”
Much as crypto-currencies run the gamut from relatively established first movers like bitcoin to ICO’s such as “Lehman Brothers Coin” (Almost Daily Grant’sJan. 19), so does the exchange-traded fund realm range from the simple (such as the SPDR S&P 500 ETF Trust, or SPY on NYSE Arca, which today crossed the $300 billion in assets under management for the first time), to the exotic.
For a demonstration of the latter, we turn to the BMO Rex Microsectors FANG+ Index 3x Levered ETN (FNGU on NYSE Arca) and its evil twin, the FANG+ Inverse Leveraged ETN (FNGD on same), which debuted yesterday.   Bloomberg Intelligence harkened the vehicle’s debut with the apt headline: “Leveraged FANG ETNs Aim to Bring Volatility to Bored Traders.”  The ETN will charge a 95 basis point expense ratio (10 times the SPY), while the underlying FANG+ Index comprises equal weighted holdings of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc., and Alphabet, Inc., (nee Google), as well as Alibaba Group, Baidu, Inc., Nvidia Corporation, Tesla, Inc., and Twitter, Inc,.
Eagle-eyed readers will spot that those leveraged securities are classified as ETNs, or exchange traded notes, rather than the conventional ETFs.  The Wall Street Journalexplained the difference on Feb. 5, 2017:
Both ETFs and ETNs track the price of things like baskets of stocks, bonds or commodities, but they do so differently. ETFs own a portion of the assets they track – an S&P 500 ETF, for instance, owns stocks that are included in the index. ETNs don’t own a portfolio of assets. They are simply debt issued by banks that promise a return to the investor linked to the performance they track.
Indeed, the registration statement filed with the SEC states that: “The notes are unsecured [and] . . . do not guarantee any return of principal.”   As for the leverage factor, the document carries the following disclaimer: “The notes are riskier than securities that have intermediate- or long-term investment objectives, and may not be suitable for investors who plan to hold them for a period other than one day or who have a ‘buy and hold’ strategy . . . Investors should actively and continuously monitor their investments in the notes, even intra-day.”
The May 19, 2017 analysis in Grant’s (“Loaded for bear”) took a different tack in describing these products which evidently require a day trader’s attention (and attention span): “Take every known principal of long-term investment success, negate those precepts and multiply the negative by leverage. That would be one aspect of the 4X, 3X or 2X story.”  Why?   Biff Robillard, co-founder of Bannerstone Capital Management LLC, explained the problem:  To make money in leveraged ETF’s, one must correctly predict not only the direction of prices, but of their realized volatility as well.
Not the implied volatility, and not the VIX per se, [but] the actual volatility that the underlying entity driving valuations will experience going forward. You have to have an opinion about that. High volatility reduces, even reverses, returns on leveraged ETFs.
The piece then goes on to demonstrate a hypothetical example:
Say that you own $100 of a thrice-leveraged ETF. On day one, the underlying index moves up by 5% – your fund as gains three times $5; it’s worth $115. Next day, the index falls by 5%; oops, your fund is now worth $97.75. Repeat across 10 days – alternating up 5% and down 5% – and you would finish with $89.23, down by 10.8%. Over the same course of choppy trading days, an unlevered fund would have lost only 1.2%.
So too, does the leverage mandate pose the potential to exacerbate market volatility, should this period of historic serenity be interrupted:
In a conventional margin account, leverage ratios fall as the value of portfolio assets rise. Not so here. An ultra ETF keeps its leverage constant by boosting its indebtedness – drawing on its swap arrangements – as the value of its assets appreciates. To bulk up in a rising market and sell down in a falling one is a technique that recalls the misadventures of portfolio insurance [an aggravating factor in the 1987 stock market crash].
For its part, BlackRock has steered clear of leveraged ETFs. CEO Laurence Fink told the audience at a Deutsche Bank-hosted investor conference in 2014 that: “We’d never do one. They have a structural problem that could blow up the whole industry one day.”  That prompted a rejoinder from Trevor Hewes, spokesman for ProShares, which offers many such products: “Leveraged ETFs are well regulated, transparent products and there is no credible evidence that they have any harmful effect on the markets or our industry.”
For our part, we wonder about the soundness of ETFs as a whole, not just the plainly perilous leveraged variety.  Recall the increasingly distant (in terms of time elapsed and market environment) events of Aug. 24, 2015, a steep sell-off that left the S&P 500 lower by as much as 5.2% intraday and 3.9% by the close.  In that session, even straightforward ETFs were severely dislodged, with the SPY falling by nearly 8% intraday.  The S&P 500 equal-weighted index dropped by as much as 4.6%, while the Guggenheim S&P 500 equal-weight ETF sank by as much as 43%, before finishing in the red by just 4%.
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The flow of capital into passive investment strategies has intensified into a veritable deluge. Last week, BlackRock, Inc. reported third quarter net inflows of $96.1 billion, bringing its year-to-date influx to $264.3 billion, and easily surpassing 2016’s take of $202.2 billion. ETF industry assets, under its iShares umbrella, posted 32.1% year-on-year gains in the third quarter.
BlackRock’s primary competitor Vanguard Group is seeing an even more pronounced surge in popularity, attracting a net $291.7 billion in new funds for the first three quarters of 2017 to put John C. Bogle’s not-for-profit enterprise on pace to eclipse last year’s inflows of $323 billion. Count current Vanguard chairman and CEO F. William McNabb among those surprised by the prodigious 2017, in an interview last Tuesday with The Wall Street Journal he noted that “last year was one that I never thought we’d see again.”
The potent force of momentum — shown here in the dual form of the longstanding bull market and growing popularity of indexation strategies — plays a starring role in the cash pile up.  So too does a helpful nudge from regulators.  Both in Europe (in the form of MiFID II regulations set to take effect in 2018) and in the U.S. (with the Department of Labor’s fiduciary rule requiring increased disclosure on commissions), investors are being herded to lower cost products.  On BlackRock’s second quarter conference call in July, chairman and CEO Larry Fink cited the government paradigm: “We’re seeing regulatory changes change the ETF environment. We do believe we’re seeing accelerated flows because of MiFID II, because of the movement toward the fiduciary rule in the United States.”
First you get the assets… BlackRock‘s five year stock price. Source: The Bloomberg
The bourgeoning popularity of indexation isn’t translating into better economics for its architects. To the contrary: Judging by recent moves from smaller industry players such as State Street Global Advisors and Charles Schwab, a full-on price war is underway.  Last week, Barron’s reported that Charles Schwab launched the Schwab 1000 Index ETF, which covers 90% of the entire U.S. equity market according to the company, at an expense ratio of just five basis points (by comparison, institutional cash equity trading commissions used to frequently top 10 basis points). This morning, State Street responded in kind, slashing its own fees on 15 separate ETFs.  For its SPDR Portfolio Total Stock Market ETF, three basis points is the new expense ratio, down from 10 basis points.
The capital gusher into ETFs and other passive instruments corresponds with the almost-robotic upward march in the stock market.  A dispatch in Bloomberg Businessweek detailed the somnolent environment at the midtown prime brokerage desk of Credit Suisse Group AG.  Noting the absence of client reaction to the escalating tensions with North Korea in August, Credit Suisse’s global head of risk advisory Mark Connors marveled that: “Two rockets flew over the land mass of Japan and nothing happened. There were no calls. That’s absolutely crazy.”
Fueled by unprecedented conditions such as negative nominal interest rates in large swaths of Europe and sustained central bank asset purchases despite the absence of recession in any major economy, the bull market continues apace.  The severe dislocations of many ETFs relative to their underlying net asset values seen back on August 24, 2015 (in which one-fifth of all equity ETFs experienced price movements of 20% or more, compared to just 4% of individual stocks, according to Bob Rice of New York-based Tangent Capital) begs the question of what becomes of the passive uprising if and when conditions do shift.
As always, the timing of any such potential sea change remains a mystery. Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, says: “I don’t think there’s much that changes these flows until we have a negative market. I can’t tell you when that happens, but when it does there will be a lot of very surprised investors.”

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Asymmetry in the market deals with probabilities and expectations. Probability is nothing more than a math calculation that tries to deal with uncertainty or the unknown, which is of course the future.

Volatility is low. Lower than it has been for, well almost forever. Articles are being written on how low volatility is, what it means, is this a new paradigm, etc.

Obviously this is a time to buy volatility, that should it return, could provide that asymmetrical outcome sought. My favourite target in these circumstances are yield hogs. These chaps buy high yield, mostly junk, for the returns as against say treasuries.

With volatility so cheap…you can buy volatility a long way into the future, to allow time to work in your favour, for pennies. That will be my trade on Monday when the markets re-open. My candidate is prepared.

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Greece. I have no idea what will finally eventuate, but you have to think that the country continues to exist in some form and that its productive businesses continue. So you buy Greece now, while the blood is in the street.

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IN THE SEARCH FOR THE NEW and different indexes that will power a new and different ETF, back-testing plays a critical role. Index providers, including S&P, Dow Jones, MSCI, Russell, Zacks and others can index just about anything. You want to rank the companies in the S&P 500 by earnings growth, then take the 50 top firms and weight them equally? Weight them by market capitalization? Go long the top 50 and short the bottom 50? They can build it. And then they back-test it. Indexes that look good in hindsight have a shot to become ETFs. Those that don’t, don’t.

Given our quantitative roots, we are sympathetic to the fact that backtests are often used as an input into making investment decisions. But past returns, as we all know, do not predict the future. And we think backtested results may be particularly problematic today. Very little fundamental data for US equities extends back more than 30 years, but the last 30 years were a period generally accompanied by two related phenomena: increasingly easy monetary policy and falling interest rates. In particular, the wave of liquidity and stimulus provided in the wake of the Tech Bubble coincided with unprecedented levels of credit expansion, rising asset correlations and record earnings volatility.

I’m not really posting this for the returns, it just gives a quick guide to what ETF’s are available.