The MLP ETP space has gotten very crowded very quickly. The products have been a success, too: Thanks to a wholesale compression of yields across every asset class, investors have flooded the segment. Most of the assets are in just two products—the Alerian MLP ETF (AMLP) and the JPMorgan Alerian MLP ETN (AMJ)—but there are nine different products in all that have cumulative assets of more than $100 million each.
Despite the popularity of MLP ETPs, they remain some of the industry's most misunderstood products. MLP ETPs are not like other ETPs. Since MLPs inhabit a very specific pocket of the tax code, their incorporation into ETPs is not seamless. In fact, there's a specific rule: RIC-compliant 1940 Act mutual funds (the structure of most ETFs) can hold no more than 25 percent of fund assets in limited partnership (LP) interests.
That makes squeezing 100 percent MLP exposure into an ETP difficult, so ETF issuers have tried various creative ways to get around this problem.
The first products to market, which also happen to be the two largest products in the space, circumvented this restriction in different ways. AMLP was structured as a C Corporation as opposed to an open-end mutual fund, while AMJ was structured as an exchange-traded note. In choosing these two paths, the two products drew a massive line in the sand and forced investors to make a number of trade-offs.
A third version appeared in 2012 with the launch of the First Trust North American Energy Infrastructure ETF (EMLP), which uses a traditional 1940 Act structure and bears the dilutive consequences. Understanding the pros and cons of each structural choice is the key to evaluating the ETP options in the MLP space, perhaps even more than understanding things like the exposures of the tracked indexes or the efficiency of each product.
This truly makes MLP ETPs unique. It's the one asset class in which the way the ETPs are structured matters as much—or more than—what they actually hold.
The C Corporation
An individual master limited partnership passes through income and any other distribution to shareholders untaxed, which makes them great yield vehicles. But because of the restrictions on holding MLPs in a mutual fund, it's difficult to create a great high-yield MLP mutual fund product.
One way to get around this is to structure your ETP as a C Corporation. There are currently five MLP ETPs on the market that are structured as C Corps. As the name suggests, these funds are actually just companies—like Apple or Exxon. As plain-old corporations, they can hold any asset any company can, including stakes in any limited partnerships.
The trade-off for this is that they must pay corporate income taxes, typically 35 percent. What's worse, even after paying those taxes, any income distributions made to shareholders are just like any distributions paid by Apple—they're dividends, and will be subject to taxes on their shareholders' returns.
If this double taxation sounds terrible, it is, and detractors love to point to this double taxation as a way of saying MLP C-Corp ETPs are a bad idea.
It's important to remember, however, that underlying MLPs make two kinds of distributions: income, and return of capital. Anything classified as return of capital is not taxed; rather, it simply lowers an investor's cost basis in the MLP. That return-of-capital status is passed through the C-Corp structure to the investor.
So far, the majority of dividends paid by the industry's leading C-Corp ETF, AMLP, have been eligible to be treated as return-of-capital distributions, much like the distributions of the underlying MLPs themselves. That's tax-free yield, but it may come at a price: Because return of capital lowers your cost basis, investors will realize higher tax liabilities when they sell.
Further, these tax-deferral benefits are completely lost when you hold a C-Corp ETF in a deferred account such as an IRA. The distributions from a C-Corp ETF made within an IRA will be treated as any other distribution, and won't lower the cost basis of the shares held within said portfolios.
Another key consideration for those considering a C-Corp MLP ETF is their investment horizon and its implications for estate planning. Although the tax-deferred nature of distributions means the cost basis in the ETF will be lowered each time a return of capital is made, the tax code allows for a "step up" in cost basis when shares are inherited, resetting the basis to fair market value and effectively avoiding all capital gains on the estate transfer.
As such, investors seeking to invest in MLPs via the ETP wrapper indefinitely—with an estate plan in place—may favor the C-Corp structure due to this step-up in basis. On the other hand, investors with shorter investment horizons will neither realize this inheritance tax break nor will they derive much benefit from the more straightforward deferral of taxation.
One last wrinkle—cost basis can never go below zero. So if you hold a high-yielding C-Corp MLP ETP long enough, distributions may wipe out your cost basis, and all future payments will be taxed in the worst possible way—as ordinary income.
The ETN Structure
Unlike C-Corporation ETFs, MLP ETNs are exceedingly simple. Like all ETNs, they are simply a debt instrument issued by a bank. The notes do not represent any beneficial ownership in actual MLPs—they don't "own" anything any more than your T-bills "own" anything. They are merely a promise to pay the return of an index of MLPs. To satiate those who come to the MLP space for income, MLP ETN issuers have built their products to make coupon payments that mimic the distributions of the MLPs in the index.
The problem, of course, is that these payments are just bond coupons: Distributions from MLP ETNs are taxed as ordinary income, while changes in price are treated as capital gains, just like any other bond. This has the advantage of simplicity: Unlike direct ownership of the MLPs, investors are not partners in the ETN, and don't have to file a K-1 statement with their income taxes. Unlike the C-Corp-based ETPs, distributions are never double taxed, whether they're income or return of capital. As a result, ETNs tend to outperform when a greater share of distributions are income.
The downside for ETNs is counterparty risk: Because ETNs are just unsecured debt, in the event of bankruptcy, ETN holders could theoretically lose all of their money, just like any bondholder.
Since an ETN only provides replicative returns rather than representing fractional ownership in any actual MLPs, total return is of paramount importance for ETN holders. Whether those returns are driven by distributions or index appreciation means significantly less to ETN investors, since there is no tax deferral available. As such, investors who expect distribution growth to be a relatively lesser component of their total returns would favor the ETN wrapper.
1940 Act ETFs
Whereas the C-Corporation and ETN structure each ask you to make significant tax trade-offs to get diversified MLP exposure, EMLP and two other recently launched 1940 Act ETFs ask you to accept a different trade-off. Since the tax code prevents these funds from holding more than 25 percent in MLPs, these products offer diluted exposure to actual LP interests in MLPs. They either own institutional MLP shares, which pay stock dividends, or own general partnership interests, which both increase concentration and carry lower yields. The remainder of the portfolio is made up of everything from utility firms to Canadian energy firms that the index providers have deemed to have similar characteristics to MLPs.
Unfortunately, this means none of these funds provides a perfect proxy for a diversified basket of MLPs, but rather an energy infrastructure portfolio with a smattering of LP interests in MLPs. The good news is these funds don't have to deal with double taxation or counterparty risk.
Ultimately, there's nothing as efficient as holding MLPs directly. ETP packages achieve many laudable goals, including offering diversified and liquid exposure in a single wrapper. But it's important to understand the trade-offs you're making when acquiring each fund.
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