A few months ago, I was interviewed about MLPs and exchange-traded products by Roger Conrad, co-editor of MLPProfits.com. Given the high level of interest in these investment vehicles, I’ve decided to share that interview with readers this week.

Roger Conrad: How many exchange-traded funds specialize in master limited partnerships?

Benjamin Shepherd: Right now, I’m tracking seven ETFs and exchange-traded notes (ETN) that focus on MLPs. But not all of them are worth investors’ time. Some of them are based on very narrow indexes, which may be great for institutional players but offer little value for retail investors. Others are simply too expensive.

Roger: What’s the difference between an ETF and an ETN?

Ben: An ETF is just a basket of stocks, commodity futures or some other hard investment that’s designed to mirror the sector performance of that investment. If one is pegged to a specific stock index like the S&P 500, that ETF will literally hold every stock in the S&P 500, and at least initially, in proportion to how that stock is weighted in that index.

An ETN is designed to do much the same thing but is organized much differently. Rather than a basket of stocks, it’s actually a junior unsubordinated debt agreement. Its performance will still mirror the investment sector or index it’s designed to track. But at its core, the ETN is a debt obligation of the issuer.

The popular JPMorgan Alerian MLP Index (NYSE: AMJ), for example, is really an obligation of JPMorgan Chase (NYSE: JPM). Theoretically, should Morgan go belly up so would the ETN, even if MLPs were the hottest investments on Wall Street. That’s a major reason these ETNs have had trouble catching on in recent years; in the event of a bankruptcy, ETN investors would more often than not be left with nothing, whereas ETF investors would get cashed out at net asset value. The memory of the 2008 crash is just too fresh.

Roger: Why would someone prefer an ETN to an ETF?

Ben: The key advantage of ETNs over ETFs for the issuer is that they’re much more profitable to run. The key advantage for investors is they’re more tax efficient than ETFs. Because ETNs are effectively obligations of the issuer, they enjoy the flexibility to avoid taxes on distributions that ETFs cannot. That flexibility also allows issuers to offer more specialized fare, or what I like to call exotic exposure in portfolios.

In the MLP universe, an example would be UBS E-Tracs Alerian Natural Gas MLP Index ETN (NYSE: MLPG), which tracks only MLPs that hold natural gas infrastructure. I’m not saying you couldn’t do the same thing in an ETF, but it would likely be a great deal more cumbersome, particularly with the current MLPG market capitalization at just $10.87 million.

Roger: What about taxes?

Ben: On the plus side, investors in ETFs and ETNs avoid the complications of investing in individual MLPs. There are no K-1s to file at tax time. And no matter how much of them you own, you won’t owe any UBTI, either. This really simplifies the complexity of holding MLPs in IRAs and other tax-deferred accounts. In fact, the ease of IRA investing is one of the main reasons these investment vehicles were launched.

On the negative side, investors who own MLPs in ETFs or ETNs lose what’s historically been the key benefit of owning this asset class: the fact that MLP distributions are, in large part, return of capital (ROC).

As your readers know, you don’t pay tax on the portion of the distribution that’s return of capital in the year you receive it. Rather, ROC is subtracted from your cost basis. When you sell the MLP, you pay the difference between the cost basis and selling price. But you pay at the long-term capital gains rate, which is generally the lowest rate available. And if you will your MLPs to your heirs, there’s a step-up in the cost basis to the current market price. That tax liability is literally wiped clean.

Again, if you own MLPs in an ETF or ETN, you’ll be paying taxes in the year you receive income. It will be easier to file taxes. But you’ll be paying more of them.

Roger: My co-editor Elliott Gue and I believe strongly that investors, particularly those looking to lock in high dividends, will do better picking their own MLPs, rather than buying an ETF or ETN.

Some of our readers, however, are looking for short-term trades on the sector, either bullish or bearish. And some are looking for ways to hedge their exposure in what have become rather large MLP portfolios. How can ETFs and ETNs help them?

Ben: First of all, I disagree with your premise that there aren’t some interesting longer-term ETF/ETN plays on MLPs. It really does depend on what investors’ objectives are. And the structure has allowed major brokerages to get creative.

The important thing is for investors to know what they’re buying and to look for the vehicle that most closely tracks what they want to do. That’s in large part a function of liquidity–the larger its market capitalization the more true the ETF/ETN’s performance will be to what it’s been set up to follow. Usually, the first-movers to a sector will be the largest and therefore the best plays, though that’s not always the case because a good launch can push a particular ETF/ETN into the leading position.

Roger: If the first-movers and largest ETFs/ETNs are the best plays, is there really any need for so many specializing in MLPs, or any other sector for that matter?

Ben: Frankly, no.

What I see is that firms throw ideas against the wall when they create new ETF/ETNs, just as they do any products. They throw something out there, and if it works, great. You only need $20 million for the typical ETF/ETN to be profitable and for management to be able to justify keeping it around, so the profits come pretty quickly.

And if something doesn’t work, they get rid of it and move onto something else. Five or 10 ETFs/ETNs in a particular sector can become two in a hurry. That doesn’t mean investors lose anything when one is liquidated. But it does demonstrate pretty clearly that these firms don’t have any real attachment to any of these vehicles. In fact, many ETFs/ETNs are really just money-making gimmicks for their issuers.

The increased competition is one positive that comes out of all of this, though. As a niche becomes more competitive, it’s not uncommon to see expense ratios charged by most–if not all–of the funds operating in it fall. Lower expenses are always a good thing.

Back to your question about using ETFs to hedge a portfolio of MLPs; there is a vehicle. It’s UBS E-TRACS 1X Short Alerian MLP Infrastructure ETN (NYSE: MLPS). It’s an ETN, and so the obligation lies with UBS (NYSE: UBS). Its value is set up to rise one percentage point for every percentage point decline in the Alerian MLP Infrastructure Index. The Infrastructure Index is a subset of the greater Alerian MLP Index and owns many of the MLPs in your Conservative Holdings.

The sister ETN to UBS E-TRACS 1X Short Alerian MLP Infrastructure is UBS E-TRACS 2X Leverage Long Alerian MLP Infrastructure ETN (NYSE: MLPL). It’s based on the same index and is also a UBS obligation. The difference is that it’s set up to rise two percentage points for every one percentage point rise in the Alerian MLP Infrastructure Index.

To be honest with you, I wouldn’t use these funds to leverage or hedge a portfolio of MLPs. The reason is that both reset their holdings on a monthly interval. Unless you’re resetting your MLPs along with them, you’re not really going to hedge your holdings, other than in a very general, sector-focused way. This reset means that over time, these ETFs and ETNs are not going to perform even remotely like the index. They’re really only good for holding a few weeks–that is, in between resets. And if you’re holding on the day that the resets hit, your position will get totally out of whack.

What investors have to understand is that most ETF/ETNs have been created for the sole purpose of allowing institutional traders to run their unique strategies. They’ll gladly take on individual investors, as that increases the market capitalization of the ETFs/ETNs, and their profits. But they really didn’t design a lot of these products with your average individual investor in mind.

Roger: What ETFs/ETNs should our readers consider?

Ben: Alerian MLP ETF (NYSE: AMLP) is an exchange-traded fund that tracks the price and yield performance of the Alerian MLP Infrastructure Index of 25 fee-generating MLPs. UBS E-TRACS Alerian Natural Gas MLP Index ETN (NYSE: MLPG) is an exchange-traded note–and an obligation of UBS–that tracks the Alerian Natural Gas MLP Index. I’m willing to overlook the fact that it’s an ETN because it provides sector exposure to natural gas infrastructure MLPs, which are profiting from the explosion in shale gas drilling in North America.

The Alerian MLP ETF is a pretty good way to hold a number of the MLPs you like–such as Enterprise Products Partners LP (NYSE: EPD)–in a reasonably low-risk way. It’s also managed to achieve escape velocity as an ETF with a market capitalization of $292 million, largely because it’s the only pure ETF in this sector. The rest are ETNs, which still have that stigma of being too closely tied to the fortunes of major banks.

As I said, UBS E-TRACS Alerian Natural Gas MLP Index ETN is alluring mainly because I can have exposure to a sub-set of MLPs that are attractive now. It’s not nearly as liquid as Alerian MLP ETF, with less than $11 million in market capitalization. But it is the only game in town. The bid/ask spread stays fairly tight, but if you want to take a position definitely use limit orders rather than market orders.

Roger: What about the most popular MLP ETF/ETN, JPMorgan Alerian MLP Index?

Ben: If someone wants the broadest possible exposure to US-listed MLPs, this is definitely the one to look at. It was first to the party and now has a market capitalization of nearly $2 billion.

My concern is that it holds literally everything in the sector, including quite a few MLPs that have nothing to do with energy. That could leave it vulnerable to legislation that would do away with the use of carried interest tax shelters.

On the plus side, the Alerian’s performance will definitely mirror the popularity of MLPs, and it has done quite well since the market bottomed in March 2009. But you’re definitely getting the bad as well as the good. It’s also an ETN, and so uniquely vulnerable any time the market starts to worry about the health of major banks.

Roger: What’s your view on the commodity-based vehicles such as United States 12-Month Oil Fund LP (NYSE: USL), which we track in the MLP Profits How They Rate coverage universe?

Ben: As you know, these are not really ETFs or ETNs, though they are definitely similar in some ways as exchange-traded products. They give the investor a way to own an asset and participate in its appreciation with minimal complications–in this case oil, gasoline, heating oil and natural gas.

There’s also a fairly unique risk that goes along with these types of futures-based funds because of position limit issues. United States Natural Gas (NYSE: UNG) ran up to a huge premium at the end of 2009 because it took quite some time to get permission from the Commodity Futures Trading Commission to take a larger futures position to facilitate the share creation process. As a result there weren’t enough United States Natural Gas shares in the market, causing a big run-up in share price–something that’s not supposed to happen with exchange-traded funds. The problem was finally resolved, but it’s still a looming issue.

I think they’re OK as long as investors understand they’re not getting a play on the spot price of these commodities, but rather on the futures market price contango. Profits and losses will be determined by energy prices, and liability is limited to the purchase price, unlike commodity futures where profit and loss are theoretically unlimited. But investors should definitely understand that before buying in.

What’s New

The only new ETF launched last week was ProShares UltraShort TIPS (NYSE: TPS). The fund seeks to return 200 percent the inverse of the Barclays Capital US Treasury Inflation Protected Securities (TIPs) Index. The index tracks all US TIPs with at least one year remaining to maturity and has more than $250 million in par value outstanding.

This product is a logical addition to the market as investors worry about looming inflation. And if you want to trade the fund, it could be an attractive option. However with the fund’s derivative exposure reset daily it’s not suitable for investors who plan to hold the ETF for more than a day at a time.

Portfolio Roundup

There was no Portfolio-related news this week.