More To MLP ETPs Than Meets The Eye

January 23, 2013

Don’t be fooled into thinking MLP ETFs and ETNs are similar, because they’re not.

Early last year, it felt like there were five ETF launches a day. This year, we’ve had just two launches in three weeks, both of which are MLP products. And that, it turns out, is rather interesting.

You’d think the iPath S&P MLP ETN (NYSEArca: IMLP) and the Global X Junior MLP ETF (NYSEArca: MLPJ) are pretty similar, since they both canvass the world of master limited partnerships. But you’d be wrong.

In case you missed it, one is an ETN and the other is an ETF, and that’s where the fun starts for an ETF analyst and blogger like me. Sure, the ETF from Global X targets the smaller MLPs in the universe, while IMLP is a relatively vanilla cap-weighted portfolio of large MLPs. But the biggest difference between the funds has to do with the structure, not the exposure.

You see, the MLP product space has been a mini-obsession of mine over the past two years, as I set out on what proved to be a Hunter S. Thompson-esque trip into the bowels of the MLP ETN and ETF structures.

And to prove that I wasn’t wasting time looking at some obscure pocket of the ETF market that no one cares about, consider this: There are now 13 different MLP ETPs on the market, with more than $13 billion in combined assets. The popularity of MLPs is owed largely to an insatiable appetite for yield, and almost every MLP ETP on the market yields more than 5 percent.

Working with colleagues, including IndexUniverse Director of Research Dave Nadig, we produced the definitive paper on MLP ETPs. That paper is only available to subscribers of our ETF Analytics product, but there are some key takeaways from the paper than don’t require a deep dive.

The most important thing to remember is that holding an MLP ETP—in an ETF or ETN wrapper—bears little resemblance to holding individual MLPs.

Ultimately, it is up to you, the investors—with the benediction of your accountant—to draw a line in the sand and determine which structure best suits your needs: the ETN or the ETF.

Consequential Differences

The difference between the two structures is significant, and unless you take the time to fully analyze each structure, you run the risk of compromising a big chunk of your potential returns.

In other words, the two structures are impossible to compare, because they’re pretty much like apples and oranges.

As we discuss in the paper, a traditional fund registered under the Investment Company Act of 1940 isn’t allowed to hold more than 25 percent of its portfolio on MLPs. As closed-end fund issuers did before them, ETF issuers began structuring MLP ETFs as C-corporations.

Most MLP ETFs are therefore little more than LLCs masquerading as ETFs. Unlike when you hold individual MLPs, MLP distributions in an ETF wrapper are taxed at the corporate level before being passed along to shareholders.

The extra layer of taxation at the corporate level creates a buffer between the ETF’s total return and that of the underlying index that is roughly equal to the maximum corporate tax rate of 35 percent. The ETF is therefore underleveraged by a factor of 0.35 to its underlying index, which has a beta of 0.65.

The good news is that despite this extra layer of taxation, the deferral of taxation on distributions is still very much available to holders of exchange-traded funds such as the Alerian MLP ETF (NYSEArca: AMLP) or the Global X MLP ETF (NYSEArca: MLPA).

As such, the ETF wrapper is still a useful tool for estate planning, even if some of the tax benefits of holding individual MLPs are diluted in the ETF wrapper.

The bottom line is that it is nigh impossible for an ETF to provide pure exposure to MLPs without using the corporate structure.


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