WWII 059: Trading our Yak based ETF (YAK), Investing in Spin-offs, Thoughts on MLPs, Jana Partners Influences $WFM

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Main Topic: Trading and Tax Implications of our YAK ETF

In the last episode, we created a YAK based ETF “YAK”. In this episode we’ll discover how it is traded, and what happens with the underlying trust assets.

Our ETF is now traded on the open market under the symbol “YAK” and we have marketed it heavily to all the retail investors and investment advisors we could reach. When YAK is bought or sold on the open market, our borrowed Yaks that we used to underwrite the creation units remain untouched in the custodian trust account. In other words, creation units are not impacted by the trading of the YAK shares on the open market. Why? Because an ETF share is a right to a sliver of a creation unit.

Still following this? Let’s say our friend bought some ETF shares, and wanted to sell them. What would she do? She would sell the ETF shares into the open market.

Are there other ways of redeeming ETF shares? Well, if you own enough YAK ETF shares to equal one Yak creation unit, then you could actually exchange all the ETF shares for one creation unit, which is then destroyed, and the underlying Yaks will be turned over to you. This would normally only be available to institutional investors.

How is this different than owning shares in a mutual fund? Well, when you sell shares back to mutual fund, the fund may have to sell some holdings to generate the cash to pay you back, creating taxable gains for its holders. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis. Therefore, even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains.

Our YAK ETF holders don’t have to worry about this issue. Large redemptions are paid out in the underlying YAKs, which doesn’t affect the remaining ETF holders. Realized gain or loss of ETF shares is based on the difference between the price you paid for the ETF shares, and the price you sold them, just like a regular stock.

So how are ETF’s priced? Well let’s say that each YAK we borrowed is worth one hundred dollars, although I think Yaks are priceless. We borrowed a million yaks at tone hundred dollars apiece for a total ETF custodial account of $100,000,000. We create one hundred creation units of one million dollars each. We then break up each creation unit into 50,000 ETF shares. So the starting math is, each ETF share is worth $1,000,000 creation unit / 50,000 ETF shares = $20.00. So our starting ETF net asset value is $20.

How many Yaks does $20 buy? If we have starting ETF trust with each Yak worth one hundred dollars, then each ETF share would be worth $20 NAV/$100 value per Yak or one-fifth of a Yak.

One issue that crops up is that ETF’s trading price is the ETF's trading price is established at the close of business each day, just like any other mutual fund. ETF sponsors also announce the value of the underlying shares daily. Sometimes, the price of our Yak ETF on the open market may deviate from the underlying net Yak asset value.

What happens when an ETF price moves away from the underlying net asset value? The answer is that large institutional will arbitrage the gap away, or it will persist. Sometimes too many institutional traders move the same direction at the same time and the price of the ETF moves really far away from the net asset value - we call this an ETF flash crash.

I will discussing more about ETFs in a future episode.

Ask JB: Do you invest in spinoffs?

From Heine in Denmark

2. Do you invest in spin offs and if so will you publish a a series of case studies?

JB Says: The answer is absolutely yes. Spin-offs are a very rich area for value hunters like me. I haven't put together a case study of spin-offs, but I have added it to my to-do list purely from your interest.

I was looking into Master Limited Partnerships and it seems like a good investment as energy is on the rise again.

However it seems complicated as taxes work different when owning MLPs and I'm not down on hiring a CPA just for owning MLPs. I probably won't hold any investments in that area since I'm a beginner/intermediate investor with limited capital right now. I just wanted to gather more information.

But what are your thoughts and do you own any MLP's?

JB Says: A number of years ago, I did invest in MLPs during a period of low natural gas prices and high oil prices. What I learned about MLPs is that they have a complicated impact on your tax situation, one difficult to predict and hard to understand. As an MLP investor, you will receive a K-1 partnership return with lots of complicated numbers on it. Your CPA will probably charge you more for dealing with those K-1s. MLPs are theoretically tax advantaged because a portion of the distributions you receive are return of capital, and those are tax-free…until you sell the MLP units.

If you happen to invest in an MLP that stopped distributions during the year, you may still owe taxes on your share of the MLP’s income, even if you didn’t receive distributions. It’s a double whammy, because the share price of an MLP that stops distributions will plummet. So not only do you have a potential capital loss, you also have a tax burden so the nightmare is not over. As such, I tend to avoid MLPs if there are plenty of other good ideas out there.

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About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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