Beware MLP ETFs

July 27, 2012

ETFs have soared in popularity in the last few years. They are often the best, most efficient way to invest in an asset class. Closed-end funds (CEFs) are also an alternative way to own an asset class that can have advantages. But sometime these types of funds are not so great and in the case of MLPs that is certainly the case. Early in 2011 I posted on why owning individual MLPs is far superior to owning the ETFs, mainly due to taxes and fees. Well, a year and  a half on this argument has only become stronger. Lets take a look at some recent data and see why investors should be buying individual MLPs versus the funds.

The table below (source: Credit Suisse) shows the selection of MLP ETFs, ETNs, and CEFs available today. Needless to say there are a ton of offerings in the MLP fund space and most of them have been introduced only in the last few years.

How have these funds performed compared to the MLP index, AMZ? Well, that’s easy to find out. Go to the AMZ website and look at the latest PDF on AMZ facts. I’ll use at the 3yr and 5yr total return performance (not annualized) to compare to the table above. For AMZ we have a 3yr total return of 105% (27% annualized) and a 5 yr total return of 60% (9.9% annualized). Only 2 of these funds beat the index over the last 3 years and one one beat the index over the last 5 years. Not a good track record. And that’s before considering the after tax returns.

Tax issues are complicated to say the least. The main issues with the MLP ETF is that distributions are taxed as ordinary income. You lose the tax benefit of owning the MLPs individually. And another issue I became aware of recently was highlighted by Barrons:

Ned Davis Research’s Neil Leeson has his eye on a would-be substitute for the JPMorgan Alerian MLP Index ETN (AMJ) — whose share issuances were capped this month — and he doesn’t much like what he’s found. It’s a lesson in how crucial tax implications are when it comes to master limited partnerships.

The ALPS Alerian MLP ETF (AMLP) is structured as a C-Corporation, which means it handles taxes in a very different manner than the relatively efficient ETN. We discussed the tax implications — bad in a rising market for MLPs, good in a falling one like this year’s — briefly in our print column this weekend. Perhaps too briefly.

Leeson notes that AMLP’s annual operating expenses are now 4.86% if one adds to the 0.85% management fee the 4.01% deferred income tax expense. The 4.01% figure is disclosed in a May 9 supplement to the prospectus which you can find here.

If you were only to glance at Morningstar’s main AMLP page, you wouldn’t know about the deferred income tax expense, since only the 0.85% management fee is included. The deferred income tax expense becomes a credit when MLPs are falling, hence, this year’s 4.01% isn’t so bad compared to recent history. Leeson calculates that during the heady period of August-December 2010, the annualized fee was actually 13.56%.

“Unfortunately, this fund is a different beast altogether,” Leeson concludes.

Wow! Not to mention that the best product, the AMJ ETN is now pretty much uninvestable, or at least will trade like a closed end fund from now on. By the way, the CEF tax issues are much better than the ETFs. CEFs do returns of capital so an investor can get the tax benefit of MLPs. The downside of the MLP CEFs are the super high fees which pretty much wipes out any advantage they provide.

If investing in a non-taxable account is your only choice then there are fewer individual MLP choices but they are increasing in number. Special share classes such as KMR and EEQ where dividends are paid in shares are good candidates for non-taxable accounts. General partners structured as C-corps, KMI and WMB, are also acceptable for these accounts. More and more MLPs are creating some type of way for MLPs to be owned in non-taxable accounts.

In short, beware of the issues involved with MLP ETFs. They inferior investments to owning individual MLPs.


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