Investors have an assortment of MLP options at their fingertips. Which one works for you?
The investment community has been buzzing this year over the wave of exchange-traded products (ETPs) that focus on master limited partnerships (MLPs). There are currently five such funds available for investors, and even though most have similar holdings, there are slight differences between each option.
The biggest difference between each MLP ETP is the structure of the fund. Up until late August, all MLP funds were exchange-traded notes (ETNs), but the launch of the ALPS Alerian MLP ETF (NYSEArca: AMLP) gave investors a new opportunity.
ETF Vs. ETN
The major difference between an ETF and an ETN is the credit risk associated with the ETN. An ETF owns the underlying MLPs that make up the index, whereas an ETN is a debt instrument that will track the index via a variety of investment vehicles including futures, options, etc. This added risk might keep some investors from investing in them, but due to other tax factors, the MLP ETNs continue to attract new money.
The UBS E-TRACS Alerian MLP Infrastructure ETN (NYSEArca: MLPI) tracks the same index as AMLP, but the returns are not identical. MLPI has gained 10.7 percent since the beginning of September, while AMLP lags with a return of only 5.9 percent. But the big wild card is the credit risk of UBS, the company that manages the ETN. If you feel UBS will stand by its obligations, it's time to compare the tax structures.
MLPs do not pay federal or state income tax because the liability is passed through to the partners (owners of the MLP). There is a regulation that states investment companies (ETFs and mutual funds) cannot hold more than 25 percent of MLPs in their portfolio and therefore an MLP ETF must be registered as a C-Corporation. Because AMLP is structured as an ETF, there is a high probability its NAV will suffer because the unrealized gains on the MLP holdings will eventually be taxed by the IRS.
Simply put, an MLP ETF is responsible for higher taxes than a comparable ETN due to its structure as a C-Corporation. When the underlying MLPs are in a bull market (like now), the performance discrepancies between ETNs and ETFs are the most significant. The tax hit on the unrealized gains mean the ETF will likely underperform a comparable ETN. This is highlighted above with the MLP ETN easily outperforming the ETF since the beginning of September.
One of the biggest factors why MLP ETPs have been able to attract such large amounts of money over the past year has been the above-average yield that most pay out to investors. MLPs are required to make quarterly distributions to owners and they are also partnerships, which create an interesting tax situation. Both the ETF and ETN issue dividends quarterly, but the core difference is in how the IRS treats these distributions.
An ETF distribution is treated as a return on capital, which is then taxed as a qualified dividend. But since the ETN is actually a debt instrument, the IRS views the distributions as interest payments. Qualified dividends will incur a lower tax liability, making the MLP ETF the better choice based simply on distributions.
The current yield on the Alerian Infrastructure Index is 6.2 percent and the distributions are paid on a quarterly basis.
Better Investment: ETF Or ETN?
When it comes down to choosing an MLP fund for my portfolio, I will take into consideration all of the above. This includes the taxing of the ETF as a C-Corporation, the taxes on the distributions, the NAV, the daily volume of the fund, the index it tracks and the fees.
After analyzing the five MLP ETPs available, I chose to own the JP Morgan Alerian MLP Index ETN (NYSEArca: AMJ). The composition of the ETN is similar to AMLP and MLPI; however, there is more flexibility in the MLPs that make up the ETN. If the choice were between MLPI and AMLP, I would have to favor MLPI because at the end of the day, the ETN structure is simply the better choice at this time for my portfolio.