By Stacey Morris
Having covered the MLP and midstream investment thesis last week, we shift this week to discuss ways to invest in MLPs and midstream. Before we dive into MLP access products, we want to make this one point clear: For a US taxable investor that is comfortable with filing K-1s and state taxes, the investor is always better off buying individual MLPs directly. Full stop. If you don't want a K-1 but you want to invest in MLPs, there are a variety of access products that you can use to invest in this space and get a more user-friendly form 1099 at tax time.
If you are interested in more information around investing in individual MLPs, please check out the MLP 201 section of our MLP University. In this note, we primarily focus on MLP access products and the nuances to keep in mind when selecting a product depending on your needs, preferences, and the taxability of your account. Much of this content is also available on the Applied MLPs section of our MLP University. Alerian is not an investment advisor, and this post does not constitute investment advice (please see our disclaimers for more information).
MLP investment products: What are the options?
Depending on your investment objective, there are many MLP access products that could meet your needs and your preferences for active or passive management. The decision tree below provides a helpful overview. While there are different types of funds, such as exchange-traded funds (ETFs), open-end funds (OEFs) such as mutual funds, and closed-end funds (CEFs), they all fit into two categories - C-Corporations or regulated investment companies (RICs). Understanding the difference between C-Corp. and RIC-compliant funds is key to understanding the options for investing in MLP funds. Aside from funds, there are also MLP-focused exchange-traded notes, which are passive products and have their own unique considerations.
C-Corp. funds - Any OEF or mutual fund, CEF, or ETF that owns more than 25% MLPs will be taxed as a corporation. The result is a tax drag, which will cause performance of the fund to differ from the performance of the underlying securities or the underlying index for passive products. As the underlying securities experience gains, C-Corp. funds will accrue a deferred tax liability to account for corporate and state taxes. With the lowered corporate tax rate of 21%, tax drag going forward should be more muted relative to the 35% rate in place prior to the recent tax reform. The primary attraction of C-Corp. funds is the yield they provide, given the significant MLP weighting.
RIC-compliant funds - Funds that own less than 25% MLPs will not pay taxes at the fund level, allowing the entire return to be passed on to investors. In other words, RIC-compliant funds have no tax drag. There are other nuances to keep in mind, however. RIC-compliant funds have lower yields relative to C-Corp. funds because of their lower MLP weighting. It's also important to understand the holdings of the other 75% of a RIC-compliant fund and to make sure the exposure in the fund is what you want.
Exchange Traded Notes (ETNs) - Unlike C-Corp. or RIC-compliant funds, ETNs are unsecured debt obligations of the issuing bank, and holders of ETNs are exposed to the credit risk of the issuer. The issuing bank agrees to pay the investor a return as specified in the issuance documents. MLP ETNs can track a basket of MLPs without any tax drag, but as notes, coupons are taxed at ordinary income rates. For this reason, as we discuss below, ETNs are more suitable for tax-advantaged accounts.
Which product makes the most sense for me?
To figure out which product makes the most sense for you, there are a few considerations to keep in mind. For example, is the account where you will own the product taxable or tax-advantaged? What are you mostly looking for from your investment - yield, total-return, broad exposure? What is your expectation for MLP/midstream performance? The graphic below largely addresses these questions by covering the advantages, disadvantages, and suitability of ETNs, C-Corp. funds, and RIC-compliant funds. We should also mention that you don't need to worry about Unrelated Business Income Tax1 if investing in these products in a tax-advantaged account (read more about owning an MLP ETF in an IRA).
To further clarify, we would add that if you expect MLPs and midstream to see significant price gains, then you are probably going to be more interested in a RIC-compliant fund or an ETN to fully participate in price appreciation. An MLP ETN would give exposure to MLPs but comes with the credit risk of the issuer and is better suited to a tax-advantaged account. A RIC-compliant fund will provide less than 25% MLP exposure, and you will want to make sure the rest of the fund holdings provide the desired exposure.
If you are primarily wanting yield, then you will be more interested in a C-Corp. fund as these funds tend to provide higher after-tax income. If you are looking for broad exposure to the midstream space, an MLP-only fund is not as representative as it used to be given recent MLP consolidations. We most recently addressed this topic in a December post (read more), but we also discussed this in more detail in August 2018 (read more). When it comes to investing in energy infrastructure, investors have to choose between yield and broad representation.
Last week, we summed up the MLP and midstream investment thesis in a sentence with four points. The same cannot be done for MLP investment product options. There are many nuances to take into consideration based on an investor's preferences for returns (yield vs. total return), desire for broad exposure, tax considerations, and even appetite for credit risk.
1UBIT is the portion of income that could be taxed in an otherwise tax-exempt entity.
Disclosure: © Alerian 2019. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.
Stacey Morris is the Director of Research at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Ms. Morris engages with the investment community to increase awareness of the Alerian Index Series and support broader understanding of the role that midstream assets play in North American energy markets. Ms. Morris was previously the Investor Relations Manager for Alon USA Energy, overseeing investor communications for the corporation and its variable distribution MLP, Alon USA Partners. Prior to Alon, she covered the integrated majors and refiners at Raymond James as a Senior Associate in the firm’s Equity Research Division. Ms. Morris graduated summa cum laude with a Bachelor of Science in Business Administration from Stetson University, and is a CFA charterholder.