Investors have flocked to the $539 million InfraCap MLP ETF (AMZA), pouring more than $475 million into the fund over the past 12 months. The question is, why?
Source: ETF.com. Data as of March 25, 2018.
Though AMZA gained some notoriety awhile back, when it rose 68% over the course of 2016, the fund's more recent performance has been underwhelming, to say the least. Over the past 12 months, the fund has lost 20.29%, three points below the average for MLP ETFs:
AMZA also carries a whopping 1.93% expense ratio, placing it among the most expensive ETFs, MLP or not.
So why do investors keep returning to this underperforming, uber-expensive fund?
It's simple, really: yield—and lots of it. Currently, AMZA offers an eye-popping 33.99% dividend yield, the third-highest of all ETFs.
How AMZA achieves that yield, however, isn't so simple.
Oasis For Yield-Starved Investors
AMZA is one of 29 exchange-traded products tracking master limited partnerships (MLPs), a lesser-known corporate structure seen primarily in the energy industry. MLPs are pipeline operators, storage facilities, oil and gas refiners—any "toll road"-style business whose revenues benefit more from volume than commodity price.
MLPs are odd ducks, from a tax perspective. As partnerships, they're not taxed at the entity level. Instead, they "pass through" any taxable gains and income to their shareholders—meaning, the end investor.
Because of the stable nature of their income stream, MLPs also tend to be excellent sources of yield. The historical average yield for MLP investments hovers around 7.5%.
That makes AMZA, with its 33.99% yield, a veritable oasis for yield-starved investors, as does its recent change to monthly—rather than quarterly—payments.
AMZA's Structure Matters
Yet as it turns out, it's not immediately obvious that AMZA, or any MLP ETF, should offer such sky-high yields, because ETFs are restricted severely in how much of their portfolio can actually be dedicated to MLPs.
Because the tax rules around limited partnerships are so unusual, the IRS limits their inclusion in '40 Act funds (like most ETFs) to no more than 25% of total assets.
That makes it hard to create a pure-play MLP ETF in a traditional '40 Act wrapper. Funds that make the attempt, such as the First Trust North American Energy Infrastructure Fund (EMLP) or the Global X MLP & Energy Infrastructure ETF (MLPX), often have to supplement their direct MLP exposure with institutional shares, Canadian energy companies, even utilities. Doing so also means a dramatic hit to yield.
The C-Corporation Get-Around
One way to circumvent the 25% cap is to structure the ETF as a C-corporation. A fund structured as a C-corp works just like an Apple or an Exxon, and it can hold any asset that these companies can, including MLPs. AMZA is one of six MLP ETPs structured as a C-corp.
There's a catch, however. Funds that are C-corps must pay corporate income taxes, even if their underlying assets are pass-through. (The federal corporate rate used to be a maximum 35%, but the recent Tax Cuts and Jobs Act reduced it to 21%.)
Furthermore, any income distributions the fund makes are treated like dividends, and taxed accordingly, just like any distribution made by Apple or Exxon.