Early last year, it felt like there were five ETF launches a day. This year, we’ve had just two launches in three weeks, both of which are MLP products. And that, it turns out, is rather interesting.
In case you missed it, one is an ETN and the other is an ETF, and that’s where the fun starts for an ETF analyst and blogger like me. Sure, the ETF from Global X targets the smaller MLPs in the universe, while IMLP is a relatively vanilla cap-weighted portfolio of large MLPs. But the biggest difference between the funds has to do with the structure, not the exposure.
You see, the MLP product space has been a mini-obsession of mine over the past two years, as I set out on what proved to be a Hunter S. Thompson-esque trip into the bowels of the MLP ETN and ETF structures.
And to prove that I wasn’t wasting time looking at some obscure pocket of the ETF market that no one cares about, consider this:There are now 13 different MLP ETPs on the market, with more than $13 billion in combined assets. The popularity of MLPs is owed largely to an insatiable appetite for yield, and almost every MLP ETP on the market yields more than 5 percent.
Working with colleagues, including IndexUniverse Director of Research Dave Nadig, we produced the definitive paper on MLP ETPs. That paper is only available to subscribers of our ETF Analytics product , but there are some key takeaways from the paper than don’t require a deep dive.
The most important thing to remember is that holding an MLP ETP—in an ETF or ETN wrapper—bears little resemblance to holding individual MLPs.
Ultimately, it is up to you, the investors—with the benediction of your accountant—to draw a line in the sand and determine which structure best suits your needs:the ETN or the ETF.
The difference between the two structures is significant, and unless you take the time to fully analyze each structure, you run the risk of compromising a big chunk of your potential returns.
In other words, the two structures are impossible to compare, because they’re pretty much like apples and oranges.
As we discuss in the paper, a traditional fund registered under the Investment Company Act of 1940 isn’t allowed to hold more than 25 percent of its portfolio on MLPs. As closed-end fund issuers did before them, ETF issuers began structuring MLP ETFs as C-corporations.
Most MLP ETFs are therefore little more than LLCs masquerading as ETFs. Unlike when you hold individual MLPs, MLP distributions in an ETF wrapper are taxed at the corporate level before being passed along to shareholders.
The extra layer of taxation at the corporate level creates a buffer between the ETF’s total return and that of the underlying index that is roughly equal to the maximum corporate tax rate of 35 percent. The ETF is therefore underleveraged by a factor of 0.35 to its underlying index, which has a beta of 0.65.
The good news is that despite this extra layer of taxation, the deferral of taxation on distributions is still very much available to holders of exchange-traded funds such as the Alerian MLP ETF (AMLP) or the Global X MLP ETF (MLPA).
As such, the ETF wrapper is still a useful tool for estate planning, even if some of the tax benefits of holding individual MLPs are diluted in the ETF wrapper.
The bottom line is that it is nigh impossible for an ETF to provide pure exposure to MLPs without using the corporate structure.
Of course, where there’s a will there’s a way, and First Trust attempted to solve this problem by offering an actively managed fund—First Trust North American Energy Infrastructure Fund (EMLP) that holds an obscure institutional MLP share class in addition to traditional MLP shares.
Even though this technically allows EMLP to hold more than 25 percent of its portfolio in MLPs, it only gets the full allocation to MLPs up to 40 percent. The rest of the portfolio is made up of U.S.-listed utilities and Canadian-listed energy infrastructure firms formerly structured as “income trusts.”
In short, there’s no perfect answer for those looking to hold a diversified portfolio of MLPs that trades on an exchange.
Sure, the ETF format will provide many of the tax-deferral benefits so many investors crave, but the returns can be difficult to predict and the vagaries of the tax code too much to digest.
The ETN Option
ETNs, which at least offer 1-to-1 exposure to the index, don’t provide in and of themselves any of the taxable benefits attributable to individual MLPs.
An ETN is merely a promise to pay the return of an index, and in the case of MLP ETNs, provides synthetic exposure to MLPs.
There are no distributions; rather, there are coupon payments made to replicate the distributions of the MLPs in the index. Those coupon payments aren’t returns of capital; rather, they’re interest payments that are taxed as ordinary income.
Further, the issuer’s promise to pay is only as good as its ability to pay that return, so investors in the ETN are exposed to the credit risk of the issuer.
All that said, many investors have flocked to the JPMorgan Alerian MLP ETN (AMJ), which has almost $5.4 billion in assets—more than the $5 billion currently invested in AMLP, the largest of the existing MLP ETFs.
All this means that there’s a laundry list of considerations investors must make before diving in to the MLP ETP space, and the recent launches are a reminder of just how complex a decision that can be.
It may very well be that Global X’s junior MLP portfolio is a fantastic strategy, and the 9 percent indicative yield it currently throws off is attractive and sustainable.
The issue is that determining whether the exposure fits your needs should be the second step in your investment decision, not the first.
If you’re considering an MLP ETP, do yourself a favor and read our MLP guide. It will arm you and your advisor with the information needed to make the correct decision.
In the end, it will do you little good to pick the right basket of MLPs if you’ve chosen the wrong structure in which to hold or track them.
At the time this article was written, the author had no positions in the securities mentioned. Contact Paul Baiocchi at firstname.lastname@example.org.
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