Proposing a Play on AMJ's Lockdown

 | Jun 20, 2012 | 12:00 PM EDT
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I have been a big fan of master limited partnership (MLPs) for the last several years. These unique securities, which generally offer exposure to companies engaged in the storage and transport of energy commodities, are known for hefty dividend yields and relative stability. And, as we all know a bit too well, those two characteristics are hard to come by in the current environment -- especially in the same wrapper.

My actionable investment idea for today revolves around MLPs but has nothing to do with dividend yields, volatility, or any other traditional valuation metrics. It's based purely on my understanding of the nuances of exchange-traded products, and, perhaps, a bit on expectations or irrational investor behavior. Late last week, JPMorgan (JPM) announced that it will suspend creation of new shares of its popular Alerian MLP ETN (AMJ), effectively cutting off the mechanism that is used to bring new shares of ETFs and ETNs into circulation. More importantly, that announcement essentially means that JP Morgan has shut off the mechanism that is traditionally used to keep the prices of exchange-traded products in line with their net asset values (NAV). Once that switch has been flipped, AMJ will lack the traditional "safeguards" that kept the price of the ETN from going significantly above or below the value of the underlying assets. 

When new creations are not possible, ETPs have a funny tendency to begin trading at a premium to net asset value. It happened earlier this year when Credit Suisse shut down creations on VelocityShares Daily 2x VIX Short-Term ETN (TVIX). And it continues to happen with iPath DJ-UBS Natural Gas TR Sub-Index ETN (GAZ), a natural gas ETN that was recently trading at a premium to its NAV of about 44%. I think that same situation is going to play out with AMJ in coming weeks, creating an opportunity for investors who buy in now to profit from the inflation of a premium to NAV.

There is, of course, no guarantee that a premium will appear once new shares of AMJ are effectively outlawed. In a rational world, there would be no reason for a premium in AMJ to appear. There are a handful of other products -- both ETFs and ETNs -- that offer substantially similar exposure to a basket of MLPs. But the exact same thing could have been said of TVIX and GAZ as there are near-perfect substitutes for both of those ETNs. And yet the premiums appeared shortly after creations were suspended, and remained in both instances for extended periods of time. So while it may seem foolish for investors to inflate a premium in an ETN when there are other perfectly good (and fully-functioning) alternatives, I'm using history as my guide here.

The worst case scenario for this idea is far from unappealing. If the premium fails to materialize and AMJ continues to trade around its NAV, you'll be left with a portfolio of high yielding MLPs -- and perhaps a nice distribution check for your troubles. The upside could be meaningful based on past performances of "switched off" ETNs.

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