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A Better MLP Mousetrap?

The newest energy infrastructure ETFs try to avoid the structural shortcomings of existing MLP products.

Morningstar Analysts, 09/27/2013

Master limited partnerships, especially the kind that owns pipelines and other oil- and gas-related infrastructure, have high yields and tax-deferred distributions. These partnerships are also fairly stable entities, as many of them operate as regional monopolies. Unfortunately, there's no perfect way to buy MLPs. Owning individual MLPs requires investors to file cumbersome K-1s, and placing MLPs in tax-advantaged accounts can cause even further tax headaches. One way to avoid K-1s is to invest in an MLP fund. MLP funds handle K-1s for investors and send a standard 1099 during tax season, but the convenience comes at the price of an additional layer of taxation. Ideally, an exchange-traded fund would be able to invest exclusively in MLPs and remain a pass-through vehicle. But the IRS stipulates that any fund with more than 25% of its assets invested in MLPs must be classified as a corporation and pay corporate income tax. This has caused funds tracking MLP indexes to significantly underperform their benchmark. For more details on these tax issues, see our earlier article. MLP exchange-traded notes (which are different from exchange-traded funds) offer one way to get around the 25% partnership limit, but they too have some drawbacks. ETNs have credit risk, and because they don't actually hold the MLP assets, their distributions are taxed as ordinary income.

Fund companies are currently launching new ETFs to address these issues. These new MLP ETFs qualify as pass-through entities by only devoting 25% of their assets to MLPs, and the remaining 75% to other, similar assets. The new ETFs are structured as Regulated Investment Companies, or RICs, and won't be taxed at the corporate level. Global X recently launched Global X MLP & Energy Infrastructure ETF MLPX, which tracks the Solactive MLP & Energy Infrastructure Index. ALPS is set to launch an ETF based on the Alerian Energy Infrastructure Index, or AMEI, as soon as November.

Are these new ETFs a credible alternative to C-corp ETFs and ETNs? The heart of the matter is twofold. Investors trying to gain diversified exposure to energy infrastructure will want to see a reasonably high correlation between the new ETFs and MLPs. Furthermore, the new ETFs will also need to offer aftertax yields that compare favorably to existing MLP exchange-traded products to be considered a viable income alternative. A closer look at these new offerings is needed to see whether they measure up to the incumbents.

Getting Around Regulations
To qualify for pass-through treatment of distributions, the new RIC-compliant MLP indexes will only allocate 25% of their assets to MLPs. The remaining 75% of their portfolios will be allocated to other energy infrastructure assets. MLP affiliates are one such class of assets, and make up about 60% of MLPX and 30% of AMEI. An MLP affiliate is a holding company that owns the general partner of an MLP, or multiple general partnerships and other MLP ownership stakes.

Understanding MLP affiliates requires some knowledge of the MLP ownership structure. When an investor buys MLP units, they usually purchase an MLP's limited partnership units. Limited partners don't have a say in the operation of the MLP's business, but they receive most of the MLP's cash flow as quarterly distributions. An MLP's general partner, by contrast, is the entity that actually manages the MLP's operations. The general partner starts with a 2% equity stake in its partnership and also owns the incentive distribution rights, which is a structure that unites the general partner's interests with those of the limited partners. When the general partner increases distributions to limited partners, it receives an incrementally larger portion of the total distributed cash flow. General partnership units yield less than their corresponding limited partnerships but tend to grow their payouts faster. An investment in general partnerships, and MLP affiliates, is essentially a leveraged bet on MLPs. Unsurprisingly, MLP affiliates tend to be more volatile than MLPs over time but benefit more when MLPs perform well.

Most MLP affiliates, like Kinder Morgan KMI, hold multiple general partnerships and limited partner units. KMI owns the general partner of Kinder Morgan Energy Partners KMP and 11% of KMP's limited partnership units, as well as El Paso Pipeline Partners' EPB general partner and 40% of its limited partnership units. The MLP affiliates included in both funds' benchmark indexes are corporations, and after meeting holding requirements, investors would pay the qualified dividend rate on distributions.

Because the MLP affiliates present in both indexes derive their cash flow almost exclusively from energy infrastructure assets, they tend to perform in line with MLPs. We think the new funds are therefore a compelling option for investors primarily interested in MLP funds as a way to capitalize on the growth of U.S./Canadian energy infrastructure. Both new indexes offer better diversification than pure-play MLP exchange-traded products.

Two Different Approaches
The Solactive and Alerian indexes underlying these funds approach RIC compliance differently, and only about two thirds of their weightings overlap. In addition to MLP affiliates, both indexes include other kinds of energy infrastructure assets. Both are heavy in Canadian MLP affiliates TransCanada TRP (8% MLPX, 5% AMEI) and Enbridge ENB (8% MLPX, 5% AMEI). AMEI also invests in U.S. and Canadian infrastructure companies with large pipeline assets.

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