Many investors have turned to master limited partnership exchange traded funds in search of yields and exposure to a burgeoning U.S. energy industry. However, there are some special considerations when browsing through MLP ETFs.
“The average investor doesn’t understand how the structure can affect their performance” with MLPs, Eric Bright, a senior vice president at Bel Air Investment Advisors, said in a Wall Street Journal article.
Unlike other energy sector stocks, MLPs primarily deal with the distribution and storage of energy products, so their business model is less reliant on the commodities market since MLPs profit off the quantity of oil and natural gas they are able to move around. To qualify as an MLP, the companies pass through at least 90% of their income to investors, making the assets an attractive yield-generating investment. Additionally, MLPs has shown low correlation to other income assets and the broader equities market.
However, when investing in the asset class, investors need to be aware of the small differences with various investment options. For instance, the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) and the Alerian MLP ETF (NYSEArca: AMLP) are the two largest MLP-related exchange traded products on the market. AMJ tracks the Alerian MLP Index, which includes 50 of the largest MLPs, while AMLP tracks the Alerian MLP Infrastructure Index, which includes 25 pipeline and processing MLPs.
Through direct ownership of an MLP, the investor would have deal with the complicated K-1 tax document come tax day.
“If you put $100,000 in an account and own 19 MLPs, it may cost you an extra $1,000 a year in accountant fees, and maybe that’s too onerous,” Shawn Rubin, an adviser at Morgan Stanley, said in the WSJ article.
Instead, ETFs and exchange traded notes only require a single 1099 during tax season. Nevertheless, investors should also be aware of differences between the ETF and ETN structures.
Specifically, mutual funds and ETFs are legally corporations. Consequently, MLP funds are required to pay corporate taxes or a 35% federal rate on returns. Fund investors are also taxed on the fund dividends and capital-gains distributions.
Most people “don’t realize they’re being double-taxed,” Will Braman, chief investment officer at financial advisers Ballentine Partners, said in the article.
Due to the corporate tax liabilities, MLP ETFs could come with a greater expense, which would eat away at overall returns. [The Active Approach to MLP ETFs is Working]
Alternatively, hybrid MLP ETFs, or non-C-corporation MLP ETFs, have reduced direct MLP holdings to under 25% to meet regulatory rules and hold other energy infrastructure stock through subsidiaries as a way to avoid double taxation. These hybrid options include the Global X MLP & Energy Infrastructure ETF (NYSEArca: MLPX), Alerian Energy Infrastructure ETF (NYSEArca: ENFR) and actively managed First Trust North American Energy Infrastructure Fund (NYSEArca: EMLP). [Hybrid Energy Infrastructure ETFs Could Outperform MLPs]
Additionally, the exchange traded note option, AMJ, does not hold underlying investments. Instead, AMJ is considered a type of debt obligation, so the ETN tracks the underlying index minus fees. Over the past year, AMJ is up 12.1%. However, potential investors are exposed to credit risk from the underwriting bank, so if the issuer defaults then you may be left holding an empty bag.
For more information master limited partnerships, visit our MLPs category.
Max Chen contributed to this article.
CORRECTION: AMLP’s underlying index.