The key to exposure and returns with master limited partnership funds lies in how they're built for taxes
[This article previously appeared on ETF.com and is republished by permission.]
Conversations about master limited partnerships wrapped in an exchange-traded product often start with the excitement surrounding the North American energy boom and the potential for high income.
The talk then moves to the achingly dull: ETP legal structures. Or at least it should, because choosing the right legal structure may well be the most important decision you make when investing in the MLP space using ETPs.
Nothing shows this better than a simple chart of two funds using different legal structures while tracking the exact same index.
Figure 1 compares the 12-month performance for an exchange-traded note, the Etracs Alerian MLP Infrastructure ETN (MLPI) versus a C-Corporation, the Alerian MLP ETF (AMLP). MLPI returned 14.7% against AMLP's 10.6%—a difference of roughly 4% in just 12 months.
Aside from performance, an MLP ETP's legal structure also has a radical impact on how its distributions are taxed, the headline fees it charges and even what securities it can hold.
Further adding to the confusion: An investor who bypasses ETFs and chooses to hold a portfolio of MLPs directly will have a different set of tax exposures. In short, investors in MLP ETPs simply can't afford to ignore the effect of legal structure.
Pass It On
The complexity here stems from the nature of master limited partnerships themselves. MLPs produce cash flows, often from payments received for oil flowing through a pipeline. Moreover, MLPs are "pass-through entities," which means this income gets special tax treatment.
MLPS, unlike corporations, don't pay taxes on the money they earn. Instead, they pass on their income directly to the MLP owners, who in turn bear the tax burden. However, MLP cash flows to direct investors—those who own the shares of the MLP rather than through a fund—are typically not taxed as income, because the pipelines themselves are depreciating assets. Instead, the cash flows are considered in part "return of capital," lowering the tax basis of the investment.