- ETNs and ETFs can provide exposure to the midstream/MLP space without the headache of a Schedule K-1, but there are important nuances to consider when choosing the right vehicle for an investor’s situation.
- ETNs are unsecured debt obligations of an issuing bank, which agrees to pay the investor a specified return typically based on an index.
- An ETN is likely to appeal more to a midstream/MLP investor allocating in a tax-advantaged account that prefers passive investing and minimal tracking error.
Investors are often familiar with exchange-traded funds (ETFs) but may be less acquainted with exchange-traded notes (ETNs). Both vehicles can provide diversified exposure to the MLP space without a Schedule K-1. But there are key differences that may make one vehicle more suitable than the other for certain scenarios. This note introduces ETNs, their pros and cons, and when an investor may prefer an ETN over an ETF. This note should not be considered tax advice. Rather, investors should consult with their tax advisor for guidance specific to their situation.
What Are ETNs?
ETNs are unsecured debt obligations of an issuing bank, which agrees to pay the investor a specified return typically based on an index. An ETN investor should be comfortable assuming the credit risk of the issuing bank. In the energy infrastructure space, an ETN may be based on an MLP index or on an index with both corporations and MLPs. The key advantage of ETNs is that they minimize tracking error. That is because the issuing bank agrees to pay the return on an index.
Energy infrastructure ETNs typically pay a variable quarterly coupon based on the payouts of the underlying MLPs or corporations. Some of these ETNs take their fees out of the coupon payment. Some take the fees out of the value of the note. ETN documents will specify how the fee is collected.
ETN Tax Considerations
ETNs issue a Form 1099 for tax purposes, allowing investors to receive MLP exposure without a Schedule K-1. Importantly, coupons from ETNs are reported as ordinary income. They are therefore taxed at ordinary rates (i.e., 37% for the highest tax bracket). For this reason, and given other potential uncertainty around tax treatment, ETNs are generally more suitable for tax-advantaged accounts like 401(k)s and IRAs. ETNs are not expected to generate unrelated business taxable income for tax-exempt entities.
Another advantage of ETNs is that they can provide midstream exposure that is not primarily dictated by tax rules. Any fund (ETF, mutual fund, closed-end fund.) that owns more than 25% MLPs will be taxed as a corporation. For this reason, ETFs either invest predominantly in MLPs (referred to here as MLP-focused ETFs) or cap their MLP exposure at 25% (RIC compliant). An index with 50% MLPs and 50% corporations would not be as optimal for an ETF given tax rules. But it would be suitable for an ETN.
What’s the Sweet Spot for Using ETNs for MLP or Midstream Exposure?
A few key factors can help an investor determine if he or she should consider using an ETN to access the MLP/midstream space. First, the investor should be comfortable with the credit risk of the issuing bank. Assuming confidence in the issuer, the next important determinant is the type of account being used. ETNs are best suited for tax-advantaged accounts as discussed above. ETNs are index-based, so the investor should also prefer passive investing.
If an investor is indifferent to the structure (ETF vs. ETN) and could invest in a taxable or tax-advantaged account, other factors bear consideration. If an investor is really bullish on the space, an ETN may be preferred. That is because it has little or no tracking error. (MLP-focused ETFs can experience tax drag because the fund is taxed as a corporation.) Additionally, an investor may prefer the index tracked by an ETN over the underlying index of an ETF based on constituents, yield, or other characteristics. Within the Alerian energy infrastructure index suite, more indexes can be accessed through ETNs than ETFs. In short, an ETN is likely to appeal more to a midstream/MLP investor allocating in a tax-advantaged account that prefers passive investing and minimal tracking error.
What About MLP ETFs?
MLP-focused ETFs are taxed as corporations, which can lead to tax drag. However, MLP-focused ETFs provide the potential for tax-deferred income, as they replicate some of the tax advantages of their underlying holdings (read more). MLP-focused ETFs are generally more suitable for investors looking to maximize after-tax yield in taxable accounts. That said, it is common for investors to own MLP-focused ETFs in tax-advantaged accounts, but it can be suboptimal (read more). For more on accessing the midstream space through an ETF, please see this note.
For tax-advantaged investors looking to minimize tracking error while using a passive investment approach, an ETN may be preferred to an ETF (or mutual fund) assuming the investor is comfortable with the credit risk of the issuing bank.
A list of Alerian energy infrastructure indexes and their linked products can be found here.
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