Exchange-traded funds or exchange-traded notes offer investment choices designed to match the returns from a specific market sector by tracking a designated index. Several features of individual master limited partnerships - including the requirement of a different analysis approach and more complicated K-1 instead 1099 tax forms - makes MLP focused ETFs or ETNs a potentially more attractive way to invest in the limited partnership universe. The ownership of master limited partnership units comes with a combination of tax advantages and tax reporting headaches. Because of the tax ramifications of MLP ownership, there are surprisingly large return and tax differences between ETFs and ETNs that track an MLP index.
MLPs and Fund Rules Don't Mix
Master limited partnership companies operate under partnership rules. A major feature is that a partnership pays no taxes at the company level and financial results are passed through to partners to claim on their personal tax returns, thus the K-1 reporting from MLP investments. Investment companies - mutual funds, closed-end funds and ETFs - also typically fall under a tax rule that requires them to pass-through earnings and capital gains to be claimed on investor tax returns. However, to qualify for the pass-through tax status, a fund cannot have greater than 25% of portfolio holdings in partnership-type investments. To get around the fund tax rules limitations, an MLP ETF will be set up as a C-corporation. This means the ETF must pay corporate taxes on any taxable income and capital gains generated by the holdings in the fund.
An MLP ETF accounts for the corporate tax bite by calculating an accrued income tax liability from net unrealized capital gains and reported K-1 earnings. The taxes that someday must be paid are factored into the NAV of the fund. Actual taxes paid show up in the fund's operating expenses. While the fund management handles the complicated task of keeping track of profits and losses on MLP units that are bought, sold and exchanged, the bottom line result will be that the ETF's share price will significantly under-perform the index the fund is designed to track.
To illustrate: The largest MLP ETF, the ALPS Alerian MLP ETF (NYSEARCA:AMLP) holds individual MLPs to match the most widely followed MLP index, the Alerian MLP Index (index symbol AMZ). For the three year period that ended on 12/31/2013, the AMZ index recorded a 16.44% average annual return. For the same time frame AMLP earned 9.98% average total return per year. Comparing the one-year and since-inception ETF returns to the index show that the AMLP annual returns have consistently run about 38% below the index results. This number coincides with the 35% corporate tax rate plus the 4% to 5% in total operating expenses reported by ALPS. The fund's management fee is 0.85% and the remaining expenses seem to be mostly cash taxes that were paid. Also, it appears that ALPS is calculating a higher return for the AMZ index than is Alerian, which reports a 15% three-year average annual return.
The distributions paid by an MLP ETF such as AMLP will usually be classified as a 100% return of capital. This means investors in the fund will not have to claim the dividends as taxable income. The ROC distributions reduce an investor's cost basis in the fund, and if the basis is reduced to zero, the distributions at that point become taxable income.
ETNs Match Index Results, Increase Tax Costs
An exchange traded note is an unsecured debt from the issuer that includes a promise that the value of the ETN shares and dividends paid will match the designated index. Without the C-corp taxes of an MLP ETF, an ETN will do a better job of getting close to the total return of the selected index. For example, the JP Morgan Alerian MLP Index ETN (NYSEARCA:AMJ) produced an average 14.1% annual return for the last three years, very close to the return reported for the AMZ index.
The dividends paid by an ETN are fully taxable income, just like earning interest from any corporate bond. Selling ETN shares will result in a reportable capital gain or loss, with long or short-term capital gains tax consequences. With an ETN investment, the share values are backed only by the issuer's promise to pay the value of the index. There is a small, but non-zero chance that the financial company behind an ETN could default on supporting these securities.
Picking Between an ETF or ETN for MLP Investing
The tax hit on the total return an MLP focused ETF is forced to take appears to make the ETF vs. ETN choice a no-brainer. However, there are other considerations in play. For someone who wants to generate a high and growing after-tax dividend stream, the ETF may make more sense. The ALPS Alerian MLP ETF has a current yield of 6.2% of tax-free income. For even more yield, an investor could consider the Yorkville High Income MLP ETF (NYSEARCA:YMLP), currently yielding 8.9%. In contrast, the JP Morgan Alerian MLP Index ETN sports a 5.0% yield of fully taxable dividends. Paying a 40% tax rate on the dividends drops the after-tax yield down to just 3%. All of the larger MLP ETNs yield in the 4% to 5% range.
An MLP ETN would be a good selection to drop into a tax-deferred IRA account. In this case, the focus would be on the greater total return potential of the ETN, and all withdrawals will be fully taxable, but taxes on the ETN dividends will be deferred/delayed until those withdrawals are taken.
Bottom line: The choice between an ETN or ETF to get broad MLP investment exposure depends on the reason for buying the exchange-traded product. ETF investors actually end up with a higher yield on their invested dollars because the NAVs of the funds are depressed by tax considerations and no taxes are payable on the dividends. ETN investors will earn a higher total return that matches the selected MLP index, but it would help overall results if the ETN distributions are sheltered in a tax-advantaged account.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.