MLP ETP Innovation Is Alive And Well

August 08, 2013

To think all MLP ETFs and ETNs are the same is the height of folly.

When it comes to exchange-traded products focused on master limited partnerships, there’s no such thing as a one-size-fits-all strategy. Investors who have owned one of the 16 ETPs in the segment so far in 2013 have reaped returns that vary from low single digits to nearly 25 percent in gains year-to-date—and that’s not including inverse or leveraged strategies.

The reason for such variations when it comes to performance from products tapping into the same segment is linked to the various structures, their tax implications, their costs and the exposure they deliver. To put it mildly, as IndexUniverse’s ETF analysts have said before, the MLP segment is one of the most complex in the ETF industry.

“There are so many trade-offs one must make in choosing either an ETF or an ETN structure that it’s nigh impossible to compare the two on an apples-to-apples basis without making a number of leaps of faith,” said Paul Baiocchi, an ETF analyst at IndexUniverse. “As such, investors looking at MLP ETPs need to think long and hard about what their goals are, what account they intend to hold the product in and their view of distribution and share-price growth moving forward.”

This week, Global X added another ETF to the fray that underscores a new fold to the MLP ETF plot that may well turn out to be important. The new fund is registered under the Investment Act of 1940—rather than as a C Corporation as most in the segment are—and its all-in cost is much cheaper than some of the other existing ETFs in the space.

In all, the 16-security MLP exchange-traded product market is dominated by ETNs, with only a handful of ETFs available to investors, and these ETFs have different costs than equivalent ETNs because of their C Corp structure. As C Corps, MLP ETFs are required to include deferred income tax expenses as part of their overall cost structures. That taxation, while separate from the management fee, does detract from returns.

For the Alerian MLP ETF (NYSEArca: AMLP), for instance, the largest MLP ETF in the market with some $6.75 billion in assets, that tax reality bumps its overall costs to 4.85 percent a year, or $485 per $10,000 invested. Its underlying management fee is 0.85 percent, or $85 a year per $10,000 invested. Of course, the tax consequences in the ETF are called “deferred” for a reason—you might not have to pay much of the tax bill for a while, and that’s an important consideration for some investors who may want that deferral.

“Because they are structured as C Corporations, distributions are taxed at the corporate level before being passed along to shareholders, so these funds will always be underleveraged to their benchmarks,” IndexUniverse ETF analytics said in a segment report. “The factor of this underleverage is roughly 35 percent, and can be seen in each fund’s beta to its underlying indexes (beta of approximately 0.65).”

Meanwhile, most ETNs in the space, such as AMJ—the market’s oldest and second-largest MLP strategy at $5.7 billion in assets—also costs investors 0.85 percent a year, or $85 per $10,000 invested. And from a tax perspective, all distributions in an ETN are considered income as opposed to capital gains, which means they’re taxed every year at an “ordinary” rate.

That’s likely to end up to be more than the ultimate deferred tax bill an owner of an MLP ETF will pay, if for no other reason than that most MLP distributions are considered returns of capital, and capital gains taxes that an ETF owner would pay—whether long-term or short-term—are lower than ordinary tax rates that apply to ETN payouts.

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