Attracted to the yield opportunities, investors are loading up on master limited partnership exchange traded funds, but one should understand the structure of the investments, lest you hit an unwanted surprise.
MLP funds, which come with an average 5.2% yield, are a popular income-generating investment, attracting $9.6 billion in inflows this year through September, compared to $7 billion for all of 2012, reports Murray Coleman for the Wall Street Journal.
The UBS ETRACS Alerian MLP Infrastructure ETN (NYSEARCA:MLPI) has gained an average annualized 15.6% in the last three years, on par with gains in the non-yield-oriented S&P 500 Index. However, the largest MLP-related ETF, Alerian MP ETF (NYSEARCA:AMLP), has gained 10.1% annually in the past three years.
While both funds track the Alerian MLP index, the exchange traded note version has been outperforming. This can be attributed to the ETN structure. As an unsecured debt instrument that replicates the return of the MLP index, the ETN vehicle is not subject to the double-taxation effects associated with a C-Corporation.
The ETN does not technically own the underlying securities, so it avoids the corporate income taxes. On the other hand, MLP ETFs with 25% or more of its assets in MLPs are considered C-Corporations and will take the tax hit.
ETNs, though, are subject to credit risk of the underwriting bank or issuer.
In an attempt to skirt the tax problems, newer MLP-related ETFs limit MLP holdings to 25% of the total portfolio.
For instance, First Trust introduced the actively managed First Trust North American Energy Infrastructure Fund (NYSEARCA:EMLP), the first RIC-compliant MLP product that doesn't dilute the tax benefits of holding individual MLPs. However, by limiting MLP holdings to 25%, the ETF includes other energy infrastructure firms with similar characteristics to MLPs.
Additionally, the newer Global X MLP & Energy Infrastructure ETF (NYSEARCA:MLPX) also limits holdings of MLPs and includes a basket of energy infrastructure stocks to eliminate the corporate-level taxation associated with C-Corporation ETFs.
Morningstar analyst Abby Woodham, though, warns that the new breed of MLP ETFs can generate less yields than conventional MLP funds, but they may also come with lower management fees.
"This isn't anything new-these are little more than what have been traditionally known as diversified energy funds," Ron Rowland, president of Capital Cities Asset Management, an asset-allocation consultant to other advisers, said in the article.
Max Chen contributed to this article.
Disclosure: I am long AMLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.