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.
The net effect: Most of the taxes on income are deferred until investors sell their shares, at which point they pay taxes on a proportionally larger capital gain. With this opportunity comes complexity: Direct MLP owners must contend with K-1 filings and may need to file tax returns in more than one state.
MLPs in Exchange-Traded Products
The rules of the game change if MLPs are held in in an exchange-traded product, where legal structures come into play.
Exchange-traded notes and C-Corporations dominate by assets, with roughly $10 billion in each structure. Traditional ETFs are relatively new to the MLP space, with about $1 billion in assets total. Two themes are clear: Each structure comes with trade-offs; and no structure matches the exposure of directly holding a basket of MLPs (Figure 2).
Exchange-Traded Note MLPs
ETNs deliver a clear advantage: pure exposure to MLPs. They can accurately match the performance of a basket of MLPs—something C-Corps and ETFs can't do. The downside: ETNs completely forgo any deferred tax advantage on the income they produce. ETN cash flows are taxed as ordinary income.
There's irony in ETNs "pure exposure" advantage: They don't actually hold any MLPs. As debt instruments, ETNs' are backed instead by the issuing bank's promise to pay. Therefore, ETNs carry counterparty risk, unlike the competing structures. In the unlikely event the issuing bank declares bankruptcy, ETN holders must stand in line with all other creditors to recover their money.
Unlike ETNs, MLP ETPs organized as C-Corps retain some of the tax-deferment advantages of the underlying master limited partnerships. Most of the cash flows from MLP C-Corps are not taxed as ordinary income, but instead reduce the tax basis of the investor's shares (in proportion to the "return of capital" in the distribution).
The catch is that MLP C-Corps pay taxes at the fund level, an arrangement that sets them apart from ETNs and traditional ETFs. The taxes create the performance wedge seen in Figure 1 comparing the C-Corp AMLP with the exchange-traded note MLPI.
In the rising market of the past 12 months, the C-Corp lags the ETN. But in a falling market, the C-Corp would lose less money. The taxes paid by the C-Corp weaken its exposure to the underlying MLPs, effectively lowering its beta to the index.
Taxation at the fund level also shows up in high headline fees for C-Corps. Funds older than a year must report their estimated deferred tax expense in their headline fee. This explains why a fund like AMLP has an eye-popping total fee of 8.56% despite a management fee of 0.85%. The tax expense varies yearly depending on performance.
Traditional ETF MLPs
Traditional ETFs don't provide pure-play MLP exposure. They are required by the tax code to limit their MLP exposure to just 25% of total assets, diluted coverage that explains the popularity of C-Corps and ETNs. Traditional MLP ETFs such as the First Trust North American Energy Infrastructure Fund (EMLP) round out the rest of their portfolio with related holdings such as pipeline and energy infrastructure firms organized as corporations rather than MLPs.
Traditional MLP ETFs have diluted benefits regarding deferred taxes on income in proportion to their diminished MLP exposure.
Strategies & Liquidity
While ETP structures have great impact on performance, the objective of each fund matters too. Competing funds focus on various niches and offer differing emphasis on income. Most track an index, but some are actively managed. With only about 100 master limited partnerships in the marketplace, funds take concentrated positions that amplify the impact of their strategies.
A performance chart of funds using a common legal structure—C-Corps in this case—supports this idea (Figure 3). Over the 12 months ending Oct. 31, the differences between the leader, the Yorkville High Income Infrastructure MLP ETF (YMLI) and the laggard, the Yorkville High Income MLP ETF (YMLP), is a whopping 12.5%. Performance diverges among ETNs and traditional ETFs, too.
While income is hugely important in the MLP space, Figure 3 also highlights the need to check total return as well as yield.
Finally, liquidity matters when selecting an MLP fund or note. There's a noteworthy anomaly in the space: The largest ETN, the JPMorgan Alerian MLP ETN (AMJ), has suspended new creations, probably to cap the issuer's risk in hedging the note's exposure. Without a functioning create/redeem process, an ETP can drift significantly away from fair value: AMJ has traded at almost 5% premiums at times over the past 12 months, adding an element of risk for those trading in and out.
More commonplace liquidity concerns crop up too in the space despite its popularity. For example, a fund launched in April 2014, the Barclays OFI SteelPath MLP ETN (OSMS), has struggled mightily to attract investors. It often goes for days without trading a single share.
Liquidity is a good first screen when choosing among the 22 MLP ETPs on the market. For those funds that make the cut, investors should consider which legal structure meets their needs with respect to pure-play exposure and taxes, and then move on to the strategies offered by each fund.