Return Of Capital Means Tax Free
That's not the end of the story. MLPs make two kinds of distributions: income and return of capital. Any distribution classified as "return of capital" isn't taxed; instead, it lowers an investor's cost basis in the MLP (more on that in a minute).
C-corps that hold MLPs can take advantage of this distinction in distributions as well. According to the 19a-1 forms posted on AMZA's website, the majority of dividends paid by the fund have in fact been treated as return of capital.
A 33.99% dividend yield, with tax-free payments? No wonder investors have piled into AMZA en masse.
Not A Pure-Play MLP Fund
That said, AMZA achieves its sky-high yield using an unconventional portfolio, one bound to leave investors who expected yet another pure-play MLP fund potentially scratching their heads.
In addition to 31 MLPs and a handful of other energy companies, AMZA also holds 216 options contracts, including calls and puts on the SPDR S&P 500 ETF Trust (SPY), the United States Oil Fund LP (USO) and the United States Natural Gas Fund LP (UNG), the iShares 20+ Year Treasury Bond ETF (TLT), and even on competing MLP ETFs, like the J.P. Morgan Alerian MLP Index ETN (AMJ).
It also holds 18.7% of its portfolio in short positions, including USO, UNG and AMJ, as well as in options contracts on a variety of ETPs.
The reason for this is that AMZA is an actively managed MLP ETF, one of only two on the market (the other is EMLP). As such, AMZA has the leeway to employ leverage, shorting and active options strategies to help boost its current income.
Active Strategies Pay Off
In particular, AMZA has deployed to great success a common options strategy known as "covered calls." In a covered call, an investor holds a long position in a given asset, then "writes" (or sells) a call option on that asset giving the holder the right, but not the obligation, to buy it at some preset price in the future.
Covered calls act as insurance policies that can provide solid income in choppy or anemic markets. (read: "Exploring Covered Call Strategies"). According to the fund's most recent annual report, that's exactly what AMZA's fund managers have tried to do, using covered calls as a means to boost income for distribution to investors, as well as for hedging purposes.
Furthermore, AMZA takes the unorthodox stance of shorting energy prices, as represented by USO and UNG. While not a bad idea in theory, given the underperformance in the energy market of late, it seems counterintuitive on first glance for an ETF that holds energy companies to short oil and gas prices.
Yet it makes sense, given that MLPs—like pipelines and refiners—make money not on the rise and fall of commodity prices, but on how much volume of a given commodity passes through their infrastructure. (It also speaks to an existential question that underlies MLPs in general: Are MLPs an energy play, or an income one? Clearly, AMZA leans toward the latter.)
There's Always A Catch
The upside of active management is that AMZA offers truly astronomical yield. The next closest yield is offered by the twice-leveraged Credit Suisse X-Links Monthly Pay 2x Leveraged Alerian MLP Index ETN (AMJL), at 23.14%. But as an ETN, its distributions will be taxed at ordinary income rates.
The next highest yield offered by a C-corp MLP ETF, with the preferential tax treatment, is from the Direxion Zacks MLP High Income Index Shares (ZMLP), which has a dividend yield of just 11.55%.
The downsides to AMZA's approach are twofold, however. The first was alluded to earlier: All this active management comes with an exorbitant 1.93% expense ratio. That's by far the highest in the MLP space, and is the 27th-highest among all ETFs, period.
Secondly, tax-free return of capital distributions, like those offered by AMZA, also lower your cost basis, meaning investors will find themselves with a higher tax liability when it comes time to sell.
In fact, since a cost basis can never go below zero, if you hold AMZA long enough, conceivably there could come a time when its distributions wipe out your cost basis.
If so, that would mean all future distributions would be taxed at the highest possible rate: as ordinary income.
Contact Lara Crigger at [email protected]