MLP ETFs and Finding the Right Fit for Your Portfolio

Given the strength in energy and attractive yields on offer, income investors may be considering the energy infrastructure space for the first time or the first time in a while. Buying individual equities may be attractive for some, but others may prefer to own the space through an exchange-traded product for diversified exposure and to avoid receiving a Schedule K-1.(1) Today’s note looks at the two types of exchange-traded funds (ETFs) that provide MLP exposure and how investors can determine which type of fund is best for meeting their objectives. While this note focuses on ETFs, investors making an allocation in a tax-advantaged account may want to consider exchange-traded notes, which are explained here.

Why are there two types of MLP ETFs?

Most investors are likely familiar with investment vehicles like mutual funds and ETFs that are Regulated Investment Companies (RIC) under the Investment Company Act of 1940. RICs are pass-through structures, acting as a conduit of income and gains to the end investor. RICs must meet certain criteria, including a diversification test. In order to maintain their pass-through status, RICs cannot have more than 25% of their assets in MLPs. A fund that owns more than 25% MLPs will not be treated as a pass-through but rather will be taxed as a corporation. This applies to mutual funds, ETFs, or closed-end funds. Energy infrastructure ETFs are either structured as RICs with MLP exposure capped at 25% (also referred to as RIC-compliant) or as corporations with predominantly MLP exposure. Importantly, both types of ETFs provide a Form 1099 for tax reporting.

RIC-Compliant and C-Corp MLP Funds

RIC-Compliant MLP Funds (up to 25% MLPs): There are currently seven RIC-compliant energy infrastructure ETFs, including two that have exposure to utilities. Two of the seven are actively managed, while the other five are passive and track an index. RIC-compliant energy infrastructure ETFs often include exposure to Canadian midstream companies like Enbridge (ENB) and TC Energy (TRP) given the integration between Canadian and US energy markets and significant ownership of US-based assets by Canadian companies. Income-oriented, multi-asset ETFs may also be organized as RICs and own up to 25% MLPs alongside other equity income or alternative investments.

C-Corp MLP Funds (predominantly MLPs): Because any fund that owns more than 25% MLPs will be taxed as a corporation, there are not ETFs with 50% or 60% MLPs. Instead, C-Corp MLP funds predominantly own MLPs. There are currently three MLP ETFs taxed as corporations, including one that is active. C-Corp MLP Funds accrue a deferred tax liability (DTL) for gains in underlying positions and for distributions from MLPs that are a tax-deferred return of capital. The DTL is based on the corporate tax rate of 21% and typically 2% for state taxes. The DTL is removed from the fund’s net asset value (NAV). As an example, if the underlying portfolio increases by 10%, then the fund NAV will only increase 7.7% when the fund is in a net deferred tax liability status.

Importantly, distributions from C-Corp MLP funds retain the tax characteristics of the underlying securities, so a significant portion of fund distributions are typically considered a tax-deferred return of capital (ROC). These distributions are not taxable but reduce an investor’s basis in the ETF, which will result in a larger taxable gain or lower tax loss when the position is sold.

Which type of MLP ETF is best for meeting certain investor objectives?

Investors choosing between a RIC-compliant or C-Corp MLP ETF must decide what investment characteristics are most important for achieving their portfolio objectives. For example, is the primary goal income or total return? How important is the diversification of the holdings? The below discussion will reference the Alerian MLP Infrastructure Index, which is a composite of energy infrastructure MLPs, and the Alerian Midstream Energy Select Index, which caps MLPs at 25% and is rounded out by US and Canadian energy infrastructure corporations. The AMZI is the underlying index for a C-Corp ETF, and the AMEI is the underlying index for a RIC-compliant ETF.

C-Corp MLP ETFs provide higher, tax-advantaged income. MLPs offer the potential for tax-deferred income and tend to provide higher yields than their counterparts organized as corporations. Investors wanting to maximize tax-advantaged income will likely favor C-Corp MLP ETFs, which provide higher, tax-advantaged yield by nature of their greater exposure to MLPs. To frame the income difference, the AMZI was yielding 6.8% at the end of March compared to the AMEI’s 5.3% yield. Comparing the ten-year average yield for the AMZI and AMEI, the AMZI’s yield was 211 basis points higher.

RIC-compliant MLP ETFs provide greater diversification. MLP consolidations by parents, take-private deals, and other M&A activity have reduced the number of investable MLPs (read more). For investors that want broad exposure to energy infrastructure companies, a RIC-compliant product with MLPs and corporations will likely be preferred. For context, the top ten names in AMZI accounted for 85.4% of the index by weighting as of March 31, while the top ten for AMEI was 62.1% of the index.

RIC-compliant MLP ETFs arguably better for total return. Investors primarily looking for total return would likely be most interested in a RIC-compliant ETF. The potential for total return is arguably better for RIC-compliant MLP ETFs, because there is no tax drag in periods of strong performance like there would be for C-Corp MLP ETFs. That said, positive developments in the MLP space in recent years, including significant free cash flow generation and the proliferation of buyback programs (read more), has improved the potential for total return from MLP-focused funds.

Bottom Line:

Open- and closed-end funds may own up to 25% MLPs to maintain their pass-through status as RICs but holding more than 25% MLPs will result in the fund being taxed as a corporation. Funds that predominantly hold MLPs offer the potential for tax-deferred income but may experience tax drag as underlying holdings gain. RIC-compliant MLP funds have lower yields by nature of the 25% cap on MLPs but can appeal to investors seeking total return or diversified midstream exposure.

For more information on energy infrastructure investing, please see this section Alerian’s Energy Infrastructure Primer.

AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR). 

Alerian is not a tax advisor or investment advisor. This piece does not constitute tax or investment advice. Please consult your tax advisor for information specific to your situation. Alerian’s disclaimers can be viewed here.

Related research:

MLPs, UBTI, ETFs, and IRAs: What You Need to Know

MLP Exchange Traded Products Explained: ETNs and ETFs

Decisions, Decisions: Demystifying MLP Investment Options

(1) Investing in individual MLPs will come with a Schedule K-1 at tax time, but exchange-traded notes or exchange-traded funds issue a Form 1099.

For more news, information, and strategy, visit the Energy Infrastructure Channel.