Master limited partnerships and the corresponding exchange traded funds have been favored destinations for income investors in recent years, so much so that in 2014, assets held by MLP exchange traded products jumped to over $22 billion, more than double the amount those products held three years earlier.
The actively managed First Trust North American Energy Infrastructure Fund (NYSEArca: EMLP) is one of the key drivers of MLP ETF growth. Last year’s top-performing energy sector ETF, EMLP has gained fans in part because it caps its exposure to MLPs, which allows the fund to deliver more conventional ETF tax treatment than those MLP funds with C-corporation structures.
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. [MLP ETF Education]
“An unusual attribute of “pure-play” MLP ETFs (which invest solely in MLPs) is that, unlike the vast majority of ETFs, these funds are subject to an additional layer of corporate income taxes. Ironically, this effectively cancels out one of the features of MLPs that investors find most attractive: namely, that MLP cash flows typically flow through to investors without the MLP paying corporate income taxes. Assuming a 35% federal corporate income tax rate, a hypothetical 10% total return for the underlying holdings of a “pure play” MLP ETF would result in a roughly 6.5% return for fund investors (before fund expenses since the fund itself will have an expense for income taxes). This additional layer of taxation is avoided by ETFs that limit MLP allocations to 25%, including EMLP,” said First Trust ETF Strategist Ryan Issakainen in a new research note.
As investors have become increasingly aware of MLP ETF tax issues in recent years, EMLP has gained a broader following. The ETF, which debuted in June 2012, recently topped $1 billion in assets under management.