Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 29: Bank Loans]
Master limited partnership, or MLP, ETFs provide investors with an added layer of diversification and additional income generation.
While MLPs are associated with the energy sector, they have a low correlation to energy prices, along with the broader equities markets, as the assets act like a toll-road in the nation’s energy infrastructure. However, MLP ETFs have certain tax pitfalls investors need to be sure to avoid. [Morningstar Warning on MLP ETF Taxes]
MLPs build, acquire and operate transportation assets. While investors link MLPs with energy, specifically natural gas and crude oil, they are more involved with transporting the commodities. Consequently, the performance of MLPs is less dependent on commodity prices than on how much of the commodity is pushed through. [MLP ETFs in Focus After Sell-Off on Yield and Dividend Taxes]
For instance, the MLPs would exact the same toll on oil pumped through their pipelines if crude oil cost $50 dollars a barrel or $100 dollars a barrel.
With MLP funds, investors would not have to fill out the individual K-1 forms come tax season and would, instead, receive a simple 1099 form. However, MLP ETFs will come with corporate taxes for capital gains inside the ETF. According to U.S. federal law, MLP ETFs, which are registered as a regulated investment company, cannot have over 25% of its portfolio in MLPs. As such, MLP ETFs fall under a C-corporation designation and will incur capital gains taxes.