A Better MLP Mousetrap?

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 and 11% of KMP's limited partnership units, as well as  El Paso Pipeline Partners' 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.

The Solactive index assigns a fixed weight of 6.5%-9% to its six largest holdings and caps all MLPs at 4.5%, which results in a very concentrated portfolio by design. The Alerian index separates its constituents into five groups with fixed weightings (25% MLPs, 30% U.S. MLP affiliates, 10% Canadian MLP Affiliates, 15% U.S. infrastructure, and 20% Canadian infrastructure) and equal-weights stocks within each group. No individual holding makes up more than 5% of the index as a result, so its top-10 holdings make up (a still-concentrated) 44% of the index compared with the Solactive index's 66%.

Both indexes are less than a year old, which limits the availability of historical total return data. The funds' income and the tax treatment of their distributions, however, can be estimated.

How Does the Post-Tax Income Stack Up?
The post-tax yields offered by the RIC-compliant ETFs are an important consideration when determining whether the new funds are up to snuff. Most investors are drawn to MLPs for their attractive tax-deferred yield. Because the bulk of distributions from individual MLP holdings is considered a return of capital, investors only owe income taxes on their share of an MLP's taxable income, which is usually 10%-30% of a distribution, or even less. Investors pay income tax on the remaining 70%-90% of distributions when they sell their shares. This recent article provides a good in-depth look at MLP taxation. The non-MLP assets tracked by the RIC-compliant indexes are taxed as corporations, and their dividends are taxed as qualified dividend income. Distributions from the new RIC-compliant funds will therefore receive varied tax treatment.

At first glance, the expected yield on the new funds is not competitive. MLPX has a current average weighted yield of 3.2%, or 2.75% after the fund's expense ratio, and AMEI is yielding 4.0%, which will be reduced by the upcoming ETF's as-yet unannounced expense ratio. These yield figures are lower than the 6.06% offered by AMLP and the current 4.88% yield on  JPMorgan Alerian MLP Index ETN (AMJ). However, after the IRS takes its cut from fund distributions, the new funds' yields start looking much more attractive. We don't expect RIC-compliant MLP ETFs to offer post-tax yield comparable to ETFs fully invested in MLPs, making them a less attractive choice for investors primarily interested in income. However, we do expect the new funds' distributions to come surprisingly close to those offered by ETNs after taxes, because ETN distributions are taxed at a much higher rate.

ETNs promise to pay out the return of an underlying index less fees. Because ETNs do not actually own the MLP assets they track, distributions from MLP ETNs like MLPI are taxed at the ordinary income rate. The ETFs, RIC-compliant or otherwise, are pass-through vehicles, so the taxation of the underlying assets gets passed to the investor.

Let's walk through a very simplified example to estimate how each investment vehicle's yield would fare after taxes. An investor has $1,000 invested today in the RIC-compliant MLPX, the C-Corp  ALPS Alerian MLP ETF (AMLP), and the largest MLP ETN, AMJ. She has owned each fund for just over a year in her taxable account and continues to hold them. Let's assume that the investor falls into the highest tax bracket, and 80% of her MLP distributions are considered return of capital.

MLPX has a current average weighted yield of 3.2%, or 2.75% after the fund's expense ratio. About 42% of MLPX's distributions would have come from its MLP holdings over the past 12 months. After assuming 80% of those distributions are tax-deferred, ordinary income tax is owed on the remaining 20%. Our investor earned $11.55 from her MLP holdings and owes taxes on her $2.31 share of taxable income. The remaining portion of her distribution from MLPX, $15.95, gets taxed at the long-term capital gains rate. Her post-tax return is $23.39, or an effective tax rate of 14.9%. After taxes, her yield was reduced to 2.39% from 2.75%. Our investor will owe income tax on the tax-deferred portion of her MLP distributions when she sells her shares. The case would be similar for the ALPS ETF, which would have derived about half of its income from MLP holdings over the past 12 months.

AMLP yields an impressive 6.06%. If 80% of the fund's distributions are treated as return of capital, our investor gets to keep $55.8 after taxes, resulting in an effective tax rate that year of just 7.9%. She will owe income tax on the tax-deferred portion of her distribution when she sells her shares.

AMJ yields 4.88%, so an investor's payout would be $29.47 after paying the ordinary income rate of 39.6%. Her yield declined 1.93 percentage points after taxes, the steepest drop among any of the investment vehicles.

The C-corp ETF is undeniably the winner for best post-tax yield. While the ETN offers a much higher yield on a pretax basis relative to the new RIC-compliant ETFs, the yield gap between these two products narrows considerably after taxes are taken into consideration.

So who should consider the new ETFs? They're best as an option for investors who want cheap, diversified exposure to energy infrastructure growth. Total return investors who dislike the corporate tax bite of the C-corp ETFs and the credit risk of the ETNs should take a closer look. Retirees purely looking for yield, however, should stick to outright MLP ownership or even consider the ETF.

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