The relatively short history of the ETF industry has witnessed both predictable failures and unexpected successes. The hyper-targeted HealthShares line of ETFs seemed like an ill-conceived idea from day one, and few were surprised when the plug was repeatedly pulled on various iterations of the MacroShares products [see ETF Hall Of Shame: Nine Exchange-Traded Debacles]. On the other end of the spectrum are exchange-traded products focusing on the MLP market, a corner of the energy market with which many investors are relatively unfamiliar [for more ETF insights, sign up for our free ETF newsletter].
When JPMorgan introduced the Alerian MLP ETN (AMJ) in April 2009, few were aware of the new product, and even fewer anticipated that it would be a huge success. But AMJ expanded rapidly, with assets swelling to more than $700 million by the end of the year. As interest rates slid to record lows and dividend yields tumbled, many investors embraced MLPs a source of current income and AMJ’s assets continued to climb. At the end of the third quarter, assets stood at just over $1.6 billion. After witnessing the incredible success of AMJ, several other issuers have launched MLP-focused exchange-traded notes. UBS now offers four MLP ETNs, including a 2x monthly leveraged (MLPL), 1x monthly inverse (MLPS), and natural gas MLP (MLPG). Credit Suisse also offers an MLP ETN, and all of these products have experienced tremendous early success in accumulating assets.
ALPS accomplished an industry first in August of this year when the company introduced the Alerian MLP Exchange Traded Fund (AMLP). Previous MLP products had been structured as exchange-traded notes, meaning that they are debt securities whose principal and coupon payments are linked to the performance of an underlying index. AMLP, on the other hand, is structured as an exchange-traded fund, meaning that the underlying assets are shares of MLPs that make up the related index [also read Do You Need An MLP ETF?].
AMLP’s introduction was tremendously successful, and assets grew to more than $200 million in the first two months. But the fund’s launch was also met with skepticism, as concerns popped up that the marriage of the MLP sector and the ETF wrapper would create a potential tax deathtrap for investors. Some even indicated that the introduction of AMLP would create an arbitrage opportunity, arguing that the tax elections would cause the fund to consistently underperform the ETN linked to the same underlying index (i.e., go long MLPI, short AMLP).
The tax issues surrounding AMLP are indeed quite complex, and the decision made between achieving MLP exposure through an ETF or through an ETN can have a material impact on an investor’s bottom line return. But one structure is not universally superior to the other, and there are some major misconceptions surrounding the tax treatments of these two options that should be cleared up [also see ENY vs. AMJ: Energy Income Funds Head-To-Head].
Appeal Of MLPs
MLPs are limited partnerships traded on major exchanges, meaning that these securities combine the tax benefits of an LP with the liquidity of publicly-traded equities. In the U.S., MLP status is limited primarily to companies that engage in certain businesses, including the transport of energy commodities such as crude oil and natural gas. The components of indexes linked to popular MLP products generally own and operate pipelines and other energy infrastructure assets in the U.S., generating fee-based revenues that are independent from commodity prices.
There are two primary advantages of MLPs to most investors. First, MLPs make quarterly required distributions to partners, providing a steady stream of income. Second, because MLPs are partnerships, they avoid corporate income taxes at both the federal and state level; the tax liability is passed through to the individual partners. When held in tax-deferred funds, however, this advantage is diminished [read Five Ultra Popular ETNs].
That’s where some of the concerns over AMLP popped up. A Regulated Investment Company cannot have more than 25% of its portfolio in MLPs. So in order to be structured as an ETF, AMLP had to make a C Corporation election. That means–in the words of the prospectus–that “AMLP is taxed as a regular corporation for federal income tax purposes and as such is obligated to pay federal and applicable state and foreign corporate taxes on its taxable income.” As a result, AMLP will accrue a deferred tax liability if the underlying securities appreciate, and the fund would lag behind the index it seeks to track.
But there’s another side to that coin. If the underlying securities depreciate, AMLP will earn a deferred tax asset–meaning that downside volatility is also limited. That pokes an initial hole in the arbitrage opportunity, but there are additional misconceptions over tax treatments of MLP ETPs [also see ETN Investing: Facts And Fallacies].
Much has been made of the potential inefficiencies of the MLP ETF relative to comparable ETNs, but most critiques have overlooked the potential tax advantages of the ETF structure. Exchange-traded notes are debt securities issued by a financial institution (in the case of MLPI, UBS). According to the prospectus, investors in MLPI will receive payments equal to “the sum of the cash distributions that a hypothetical holder of Index constituents would have been entitled to receive in respect of the Index constituents during the relevant period.”
While the amount of the payment will be determined based on the distributions of the underlying MLPs, the actual payment to MLPI investors is not a dividend or partner distribution, but rather an interest payment (since the asset held by investors is a debt security). The current yield on the Alerian MLP Index is in the neighborhood of 6.5%, or 5.65% after deducting the 85 basis point expense ratio. That means the the impact of a 30% tax on interest payments could be about 1.7%. For investors focusing on after-tax yield, that’s not exactly pocket change [also see the Basics of ETN Investing].
Distributions made by MLP ETFs, on the other hand, will likely be viewed as return of capital–a far more advantageous treatment from a tax perspective. After a certain point, ETF distributions will be treated as qualified dividends. In order to take a complete and accurate assessment of AMLP’s tax features, it’s important to consider the advantages it offers related to distributions.
Pros And Cons
For investors interested in MLP exposure, there are potential advantages in both the ETF and ETN structures. ETNs eliminate tracking error, since they are debt securities whose performance is linked to that of an index. And if the underlying MLP securities appreciate significantly in value, the ETN structure may be more tax efficient than a similar ETF thanks to the preservation of effective pass-through status for investors [see Why ETFs Are Tax Efficient].
On the other hand, because ETFs aren’t debt instruments they are not subject to the credit risk of the issuer. While some investors gloss over the risk of default associated with ETNs, the fate of those who held exchange-traded notes issued by Lehman in 2008 serves as a cautionary tale. Moreover, for investors focusing on after-tax yield, the treatment of distributions is generally more favorable (from a tax perspective) under the ETF structure. If the underlying MLP securities depreciate or stay relatively flat, the advantageous tax treatment of distributions will offset any potential drawbacks related to the creation of a deferred tax asset or liability.
It’s also worth noting that there is some risk to the current tax treatment of MLP ETNs. MLPs generate unrelated business taxable income (“UBTI”), which is why investors generally don’t hold MLPs in a tax-deferred account. Under current tax law, ETNs linked to MLP indexes are treated as if they do not generate UBTI, but the IRS hasn’t issued a formal opinion on this somewhat gray area of the code. That’s not to say that a crackdown is coming, but it’s certainly a possibility [see Three Rock Solid Energy ETFs].
So there are potential benefits and drawbacks to both the ETF and ETN structure, and declaring one as universally superior is misleading to investors. “There are different markets for different investors,” says Kenny Feng, president and CEO of Alerian. “Alerian’s objective is providing information and product access to the MLP space.”
Race To Market
Some investors have assumed that because the first MLP ETF was introduced nearly 18 months after the debut of the first ETN tracking a similar index, the ETN structure is a more attractive option for exposure to the MLP sector. In reality, a simplified approval process for ETNs was the primary reason for the extended gap between launches. And the tremendous early success of AMLP–it has gathered more than $200 million in assets already–is a testament to the level of investor demand. “The reason the MLP has accumulated significant assets in the short term is both the familiarity with the ETF structure as well as the attractive after-tax yield,” says Feng. “With yields on U.S. Treasuries and yield-oriented equities where they are, investors are looking for after-tax yield in a sustainable and stable cash flow environment, which is what MLPs provide.”
For investors seeking to access the MLP sector, there are now more options than ever before, including mutual funds, closed-end funds, ETNs, and now ETFs. Each is unique, and different structures will be appropriate for different investors. The ETF wrapper won’t be right for everyone, but it certainly isn’t a flawed product guaranteed to underperform its peers. The lesson–as always–is to do your homework before investing.
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Disclosure: No positions at time of writing.