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ETF Specialist

Minimize Ownership Complications With This MLP Idea

This MLP exchange-traded note isn't revolutionary, but it has fewer structural issues than other popular exchange-traded products.

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Unfortunately, there's no perfect way to own master limited partnerships. It can be a paperwork headache to directly own a diversified group of MLP units, and because of various structural complications, even the best exchange-traded funds and exchange-traded notes have their drawbacks. It's rare for an exchange-traded note to be a viable alternative to an exchange-traded fund that tracks the same asset class, but  UBS E-TRACS Alerian MLP Infrastructure ETN (MLPI) is one of these unusual cases. There's nothing revolutionary about this note: MLPI tracks the same Alerian index as most MLP exchange-traded products and its 0.85% expense ratio is average. The case for MLPI is simply that it has fewer structural complications than the other two popular MLP products,  JPMorgan Alerian MLP Index ETN (AMJ) and  ALPS Alerian MLP ETF (AMLP). Investors have begun to pay attention to MLPI: It now sits at almost $2 billion in assets after more than tripling in size over the past 16 months.

What's in the Index
This note's index tracks 25 infrastructure MLPs, which are a subset of the MLP universe that specializes in "midstream" energy: the gathering, processing, and pipeline transportation of energy commodities like natural gas. Gathering and processing MLPs transport raw gas from the wellhead, process it, and move it to the cross-country pipelines. They often keep the impurities and sell them for additional revenue. Natural gas pipeline MLPs take processed natural gas and transport it through their extensive pipeline systems. They charge fees by volume with long-term contracts, so as long as the gas keeps flowing at increasing volume, pipeline MLPs will maintain good revenue growth. Petroleum pipelines transport crude oil to the processing plants and then ship the products to consumers.

Pros and Cons: MLP Tax Treatment Within an ETN (or ETF)
As an ETN, MLPI is an unsecured debt security. Unlike an ETF, an ETN does not actually own shares of the companies included in the index it tracks. ETNs promise to pay out the value of an index at its maturity, as well as the distributions that replicating the index would produce. ETNs are unsecured debt, which exposes investors to default risk. UBS' credit risk is low, but not zero.

There are two major tax ramifications of MLPI's ETN structure. On the upside, MLPI's investors receive a familiar 1099 form instead of the MLP K-1s that many find frustrating and time-consuming to handle. Come tax season, MLPI's owners will have less of a headache.

On the downside, MLPI's distributions are not tax-deferred like distributions from a direct ownership stake in an MLP. MLP unitholders are liable for taxes on their share of the partnership's income every year. Fortunately, the bulk of MLP distributions is considered a return of capital because MLPs use depreciation to offset their net income. Instead being an immediately taxable event, distributions reduce an investor's cost basis. Taxes are only owed on the distributions when an investor sells their units. At that point, the IRS views the income as recapture of past depreciation deductions, and investors will owe their ordinary income rate. Functionally, the investor is able to defer paying taxes on distributions until they sell their shares. But because MLPI doesn't actually own MLPs, its distributions are taxed as standard interest income, which can make it less appealing for taxable investors. In other words, holders of MLPI will not enjoy any of the long-term tax benefits enjoyed by those who invest directly in MLPs, either through owning units or an MLP fund.

Avoiding Idiosyncratic Complications
MLPI's tax situation is unavoidable. But what it does avoid is additional ownership complications.

The other popular MLP ETN, JPMorgan's AMJ, capped creations in June 2012. As an ETN increases in size, so do its hedging costs. At more than $6 billion in assets, AMJ is the largest ETN on the market of any kind by a wide margin. Since AMJ can no longer create new shares, the note is now essentially a closed-end product. Without a creation process (one of the key mechanisms for properly functioning exchange-traded products) in place, if demand exceeds shares available, AMJ will trade at a premium to net asset value. Supply and demand for the note became unbalanced in March 2013, and AMJ traded at a premium of 2%-5% until September 2013. AMJ's bid-ask spread has been much tighter since then, but problems could occur again. Investors who already own AMJ have little to worry about, but new investors could get burned if a premium opens once more.

ALPS' AMLP is an incredibly popular fund and has grown faster than even MLPI in recent years. This ETF offers advantages such as simplified tax filing (investors receive a standard 1099 form) and diversification. Because it is an exchange-traded fund, AMLP also passes the deferred tax treatment of MLP distributions on to its investors, which is something MLPI cannot do. However, the fund also has major drawbacks of its own. AMLP is a corporation, not a fund registered under the Investment Company Act of 1940 like most ETFs, because open-end funds are not allowed to have more than 25% of their portfolio in MLPs. Because AMLP is a corporation, the fund itself has to pay corporate taxes on the adjusted cost basis when it sells underlying investments or if it ever liquidated. AMLP accrues for this future tax liability in its net asset value, which means AMLP must give up about 38% of its return in every year when the fund's total return is positive. Because MLPs have done so well in recent years, this tax drag caused the fund to significantly lag its benchmark. On the flip side, AMLP will decline less than MLPI in a down period because it can harvest its tax liability reserve.

MLPI is best suited for investors who want to buy the total return of a diversified portfolio of MLPs while reducing their paperwork load. It's not a perfect solution, but it's a decent option for investors who are bullish on MLP fundamentals. A third option is the new crop of RIC-compliant MLP ETFs, which I discussed last year

For more on the fundamental case of MLPs, our equity analysts recently published their outlook for the sector. They also discuss the impact of the Marcellus shale, which will continue to be an important performance driver for MLPs. On the topic of individual names, Josh Peters (of Morningstar DividendInvestor) talks about the stocks he likes, as well as the companies he removed from the portfolios he runs.

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Abby Woodham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.