How to Evaluate MLP ETPs

Investors have flocked to MLPs for numerous reasons, but one of the biggest has been the ability to use an ETF to own units of these natural resource companies quite easily, and in some cases without the tax headaches that come along with owning MLPs.

But with well over 20 MLP-focused funds available, how does an investor choose the best one for their investing needs? Read on to find out.

So why would you want to own MLPs in the first place? The name of the game is high dividend distributions.

The corporate tax structure of MLPs is a “pass-through” entity, similar to a real estate investment trusts (REITs). In exchange for dropping various natural resource-based assets—which include everything from pipelines to coal mines—into the MLP, the sponsoring firm/general partner receives some hefty tax-deferred dividends. Investors who buy shares—called units—can access the similarly high distributions from the MLP. Those dividend yields typically fall within the 5% to 7% range.

Tax Headache

The drawback to MLPs comes at tax time with the dreaded K-1 statement. As pieces of a partnership, MLPs don’t come with the traditional 1099 form most investors are used to. A K-1 statement can be tricky to navigate. Adding multiple MLPs to the mix can complicate this further. Additionally, MLPs can have some consequences when placed inside a 401(k) or other retirement account vehicle.

However, by using an ETF, both of these factors are removed and investors typically can enjoy the high dividends associated with the asset class.

For investors looking at getting MLP exposure via an exchange traded vehicle, there’s one major choice to make: buying either a bread-n-butter ETF or using an exchange traded note (ETN). Both have pros and cons to consider.

Inside MLP ETFs

For MLP ETFs, one of the biggest pros is that you actually own the underlying MLPs and stocks within the fund. That’s a sharp contrast to ETNS, which are nothing more than unsecured debt obligations from an issuing bank. ETNs actually don’t own anything and simply the promise to pay investors the return of an underlying index. Investors need to consider the credit rating of the issuer before investing, as there have been times when ETNs have gone bankrupt. Bear Stearns famously had a few ETNs issued when it filed in 2008. Investors in its funds did lose out.

Inside MLP ETNs

In exchange for that credit risk, investors do have one big advantage: almost perfect correlation to the underlying MLP index. Since they don’t own anything, MLP ETNs track their holdings exactly, minus the fund’s expenses. That can’t be said for MLP ETFs. Due to IRS rules, mutual funds can’t own a high percentage of MLPs in their asset mixes. To get around this, most MLP ETFs are actually structured as corporations. That means the underlying fund must pay taxes. That tax expense, which is included in the expense ratios, can dramatically change just how well the ETF tracks its underlying index.

What About Dividends?

Another big difference is in the dividends ETNs and ETFs provide. For MLP ETF investors, dividends are considered returns of capital or qualified dividends. Both feature favorable tax treatment. For ETNs, their distributions are considered interest income.

Once investors have weighed the pros and cons of the fund structure they’d like to use, the next step is understanding the wide world of MLPs. The IRS definition of what can be placed in the structure is quite broad. Traditionally, midstream or energy logistics infrastructure has been the bailiwick of the MLPs. Pipelines, gathering systems and other processing equipment typically provide stable and growing cash flows based on fees and volumes rather than the underlying price of the commodity.

However, in recent years, various firms have expanded on the MLP definition and now a variety of upstream and downstream MLPs exist. Upstream basically refers to those firms involved in the production of oil or natural gas. These are the owners of drilling rigs, or those firms that actually prospect for oil. Downstream usually refers to refining and marketing operations. Usually, these sorts of MLPs come with variable distributions based on cash flows and are very commodity sensitive.

Dig Deeper

But MLPs don’t stop there – coal miners, forestry and paper mills, tankers and even some financial firms have adopted the structure.

That means when it comes to looking at an MLP index, investors have to dig down and really look at what they are buying. Some cover simply the midstream sector, while others include all sorts of different MLPs. This changes the risk/reward spectrum of the funds, as does market cap weighting, yield weighting, and equal weighting of the index.

Below is a brief profile of some of the largest exchange-traded instruments tracking the MLP space:

• Alerian MLP ETF (AMLP A-): The largest MLP ETF. Tracks the benchmark Alerian index, which includes the largest MLPs of any kind that pass various screening criteria with regards to dividend distributions. Tax expense is reflected in the high expense ratio.
• JP Morgan Alerian MLP Index ETN (AMJ B): The largest ETN tracking the Alerian. No longer issuing new ETN units. Can trade at discount/premium to NAV.
• UBS E-TRACS Alerian MLP Infrastructure Index (MLPI A): Tracks only the midstream sector of the MLP marketplace.
• First Trust North American Energy Infrastructure Fund (EMLP B-): Includes MLPs, GPs, utilities, and other infrastructure firms in its index. Not a pure MLP fund and is actively managed.
• iPath S&P MLP ETN (IMLP C+): Includes both master limited partnerships and publicly traded limited liability companies.
• Credit Suisse Equal Weight MLP Index Exchange (MLPN A): Tracks the Cushing 30, which is an equal weight index of the largest MLPs.
• ETRACS Alerian MLP Index ETN (AMU B): Tracks the bread-n-butter Alerian Index.
• Barclays ETN Select MLP ETN (ATMP ): Underlying index includes general partners or the sponsors of MLPs.
• Yorkville High Income MLP ETF (YMLP A-): Underlying index focuses on those MLPs with the highest dividends. This includes firms across the entire spectrum: up- mid- and downstream.
• Global X MLP & Energy Infrastructure ETF (MLPX ): The ETF includes other infrastructure firms besides MLPs in its mix. The fund is the lowest cost way to add MLPs to a portfolio.

For investors, the appeal of MLPs is certainly strong. With ETFs, accessing this asset class couldn’t be easier. Aside from the diversification benefits from holding multiple MLPs, investors are treated to favorable tax considerations and relatively low expenses. The key is to check under the hood and make sure that you’re choosing the right fund for your needs.

Both ETFs and ETNs offer pros and cons as does the various types of MLPs. Picking the correct one just takes a slight bit of legwork and this guide is a great way to get started.

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