MLP ETF is Here: Finally!

By Jim Fink • August 31, 2010 • Stocks to Watch

ETNs are actually a form of debt issued by a sponsoring institution. In other words, when you buy an ETN you’re exposed to credit risk.

— Elliott Gue, MLP Profits

Energy master limited partnerships (MLPs) continue their amazing run of outperformance vis a vis the S&P 500 index. Year to date, the total return of the Alerian MLP Index (NYSE: ^AMZ) is up 17.48% compared to a negative 4.27% return for the S&P:

Source: Bloomberg

This 21.75% outperformance so far in 2010 is on top of the best year in MLP history back in 2009, when the MLP index outperformed the S&P 500 by an astounding 50%!

Source: Bloomberg

No wonder I keep writing about MLPs! No wonder that this past June the biggest initial public offering (IPO) for a closed-end fund (CEF) in three years was an MLP fund. And no wonder MLP Profits, the investment service run by dividend expert Roger Conrad and energy expert Elliott Gue, is so popular with subscribers.

Advantages and Disadvantages of MLP Investment Options

Back in June, I wrote about three ways that you can own energy MLPs:

(1) individual MLPs like Enterprise Products Partners (NYSE: EPD);

(2) closed-end fund MLPs like Kayne Anderson MLP Investment Company (NYSE: KYN); and

(3) Exchange traded note (ETN) MLPs like JPMorgan MLP Index (NYSE: AMJ).

Each of these options has advantages and disadvantages:

MLP Product	Advantages	Disadvantages
Individual MLP	1. No taxation at company level. 2. Deferred taxation on virtually all cash distributions to unit holders.	1. Must file more complicated K-1 partnership form with IRS rather than simple 1099 form. 2. Potential tax exposure in retirement accounts for unrelated business taxable income (UBTI). 3. Slight possibility of a need to file tax returns in each state that the MLP operates.
Closed-End Fund	1. Deferred taxation on virtually all cash distributions made to shareholders. 2. Simple 1099 form. 3. Instant diversification. 4. Allegedly can beat the index by selecting only the best MLPs.	1. Corporate taxation at fund level. 2. Can sell at a premium to the funds’ net asset value. 3. Possibly substantial tracking error from underlying index since fund often has leeway to invest in non-MLP securities. 4. Management fee.
ETN	1. Virtually no tracking error from underlying index. 2. Simple 1099 form. 3. Instant diversification.	1. All cash distributions to shareholders taxed at ordinary income rates. In other words, tax deferral benefit at shareholder level is completely lost. 2. Does not hold actual MLP securities, but is debt obligation of issuer, so there is credit default risk. 3. Management fee.

In my June article, I didn’t mention an MLP ETF as an option because, well, none existed.

Until now . . .

MLP ETF is Here But Don’t Get Excited

On August 25^th, Alerian, the company that manages the benchmark MLP index (NYSE: ^AMZ), announced the launch of the Alerian MLP ETF (NYSE: AMLP). Alerian President Kenny Feng stated:

The Alerian MLP ETF provides a single Form 1099, no K-1s, and allows investors to potentially benefit from return of capital and qualified dividend tax treatment of distributions. We believe this product is the answer to what the marketplace has demanded for years and represents a breakthrough in MLP investment.

I completely .. disagree. For investors who want the instant diversification of an MLP fund, it is true that the only two previous alternatives — CEFs and ETNs — were seriously lacking for all of the reasons listed in the above table. It is also true that an MLP ETF does not suffer from the tracking error and premium-to-NAV problems of CEFs and does not suffer from the ordinary income taxation and credit default risk problems of ETNs.

However, an MLP ETF has a serious flaw that may dwarf the problems of CEFs and ETNs — corporate taxation of 35% at the fund level. Whereas almost all ETFs are classified as “regulated investment companies” (RICs) under the 1940 Act, an MLP ETF doesn’t qualify for the reduced taxation of RICs because RICs are prohibited from holding more than 25% of their portfolios in MLPs. The result is that an MLP ETF is classified as a regular “C” corporation instead of a RIC and is subject to much higher taxation. An MLP ETF is required to take account of this higher taxation by witholding 37.5% of the daily change in its net asset value. If you run the numbers, you discover that MLP ETNs outperform MLP ETFs even when taking into account that 100% of the cash distributions received by ETN investors are taxed at ordinary income tax rates.

Elliott Gue, co-editor of MLP Profits, understands the tax treatment of MLPs better than anyone (except maybe co-advisor Roger Conrad) and pointed out this salient fact recently to his subscribers when he wrote:

Because these MLP products are ETNs, the income you receive is ordinary income, NOT qualified dividends or partnership distributions. You won’t receive any of the income-tax deferral benefits associated with owning individual MLPs.

If the MLP investment is held in a retirement account, ETNs are definitely superior because shareholder-level taxes are deferred or, in the case of a Roth IRA, eliminated.

Listen to an MLP Expert

In a well-researched article dated August 24^th and entitled “Extremes in Sentiment, Not Valuation,” Elliott Gue, co-editor of MLP Profits, advised subscribers to focus on valuation, not perceived sentiment: “just because MLPs have performed well doesn’t mean they’re overvalued.”

Mr. Gue then analyzed the current spread between MLP yields and other income investments such as corporate bonds and real estate investment trusts (REITs) and compared it to historical averages. Elliott’s conclusion: MLP yield spreads are higher than average, suggesting that MLPs remain reasonably valued despite their recent outperformance.

Bottom Line

As I wrote in July, the absolute best solution is to manage your own portfolio of individual MLPs with the guidance of MLP Profits. You get maximum tax benefits and focus on only the best MLPs instead of being forced to invest in the index’s mediocre and bad ones.