Morningstar has issued a research note warning investors about the ALPS Alerian MLP ETF (AMLP).  (Morningstar)  The reason?  Hot money is flowing into this ETF because the industry giant, JPMorgan Alerian MLP Index ETN (AMJ), has hit its $5 billion asset limit and stopped creating new units.  This means AMJ is now a closed-end fund and that shares will fluctuate above and below NAV.

Here’s what Morningstar has to say about why an ETF structure (as opposed to an ETN structure) is bad for MLPs:

 However, AMLP is not the right vehicle for the majority of investors, and it represents one of the rare cases when buying the ETF structure makes very little sense.

Legally MLPs can make up only 25% of a portfolio registered under the Investment Company Act of 1940. Most mutual funds and ETFs are structured this way. To get around this issue, AMLP is actually structured as a corporation that pays income tax: Before return is passed on to the investor, it must be taxed at the corporate level. Although AMLP’s prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is almost 5% as of September. As a result, AMLP has lagged its index significantly. Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%. The upside? When MLPs are down, AMLP declines less because it can reverse some of the deferred tax liabilities it has accrued. For all but the most risk-averse yet desperate-for-yield investors, this downside protection is not enough to make up for the fund’s structural issues…

Because of legislation forbidding open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. Any taxable income from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio’s shares they must also pay up at the corporate level. AMLP accounts for these tax liabilities in the NAV, meaning that the total return of the fund can and does trail the index by massive amounts.

Thus the C-Corporation structure eliminates the deferred tax structure inherent in a MLP and pays the taxes along the way.  By Morningstar’s calculation, this comes to about 5 percent per year, and causes serious underperformance against the index.