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ETF Specialist

A Better MLP Mousetrap?

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

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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.

Abby Woodham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.