When it comes to exchange-traded products focused on master limited partnerships, there’s no such thing as a one-size-fits-all strategy. Investors who have owned one of the 16 ETPs in the segment so far in 2013 have reaped returns that vary from low single digits to nearly 25 percent in gains year-to-date—and that’s not including inverse or leveraged strategies.
The reason for such variations when it comes to performance from products tapping into the same segment is linked to the various structures, their tax implications, their costs and the exposure they deliver. To put it mildly, as IndexUniverse’s ETF analysts have said before, the MLP segment is one of the most complex in the ETF industry.
“There are so many trade-offs one must make in choosing either an ETF or an ETN structure that it’s nigh impossible to compare the two on an apples-to-apples basis without making a number of leaps of faith,” said Paul Baiocchi, an ETF analyst at IndexUniverse. “As such, investors looking at MLP ETPs need to think long and hard about what their goals are, what account they intend to hold the product in and their view of distribution and share-price growth moving forward.”
This week, Global X added another ETF to the fray that underscores a new fold to the MLP ETF plot that may well turn out to be important. The new fund is registered under the Investment Act of 1940—rather than as a C Corporation as most in the segment are—and its all-in cost is much cheaper than some of the other existing ETFs in the space.
In all, the 16-security MLP exchange-traded product market is dominated by ETNs, with only a handful of ETFs available to investors, and these ETFs have different costs than equivalent ETNs because of their C Corp structure. As C Corps, MLP ETFs are required to include deferred income tax expenses as part of their overall cost structures. That taxation, while separate from the management fee, does detract from returns.
For the Alerian MLP ETF (AMLP), for instance, the largest MLP ETF in the market with some $6.75 billion in assets, that tax reality bumps its overall costs to 4.85 percent a year, or $485 per $10,000 invested. Its underlying management fee is 0.85 percent, or $85 a year per $10,000 invested. Of course, the tax consequences in the ETF are called “deferred” for a reason—you might not have to pay much of the tax bill for a while, and that’s an important consideration for some investors who may want that deferral.
“Because they are structured as C Corporations, distributions are taxed at the corporate level before being passed along to shareholders, so these funds will always be underleveraged to their benchmarks,” IndexUniverse ETF analytics said in a segment report. “The factor of this underleverage is roughly 35 percent, and can be seen in each fund’s beta to its underlying indexes (beta of approximately 0.65).”
Meanwhile, most ETNs in the space, such as AMJ—the market’s oldest and second-largest MLP strategy at $5.7 billion in assets—also costs investors 0.85 percent a year, or $85 per $10,000 invested. And from a tax perspective, all distributions in an ETN are considered income as opposed to capital gains, which means they’re taxed every year at an “ordinary” rate.
That’s likely to end up to be more than the ultimate deferred tax bill an owner of an MLP ETF will pay, if for no other reason than that most MLP distributions are considered returns of capital, and capital gains taxes that an ETF owner would pay—whether long-term or short-term—are lower than ordinary tax rates that apply to ETN payouts.
A New And Better Way?
The variables are dizzying and complex, which is why fund sponsors may be rethinking how to wrap up the MLP space in an ETF.
“Issuers like First Trust and now Global X have brought RIC [registered investment company]-compliant products to market with the intention of circumventing some of these tax complexities,” Baiocchi said.
Because the Global X MLP ' Energy Infrastructure ETF (NYSEArca:MLPX) , the latest addition to the space, is a ’40 Act fund and isn’t structured as either a C Corp or as an ETN, its management fee of 0.45 percent is pretty much the fund’s all-in cost. It’s also the lowest of any exchange-traded MLP product.
However, that cost advantage has its own cost in terms of exposure.
The fund is not allowed to solely comprise MLPs, and in fact, only about a quarter of the portfolio consists of MLPs, diluting some of the yield-rich exposure investors may look for in MLP-focused strategies.
The original innovator in this middle-ground segment is the First Trust North American Energy Infrastructure Fund (EMLP), but the ETF, with an annual expense ratio of 0.95 percent, is pricey, at least relative to the new Global X fund that went live this week. And this pocket of the ETF world seems rife with action, as ALPS, the sponsor behind AMLP, just put a fund into registration that has the same characteristics as Global X’s MLPX.
The initial prospectus detailing the Alerian Energy Infrastructure ETF didn’t include an expense ratio, so one component of its potential allure remains a mystery for now. What is not a mystery, however, is the index. ALPS, in conjunction with Alerian, has gone to great lengths to construct an index that can be used in a RIC-compliant product while still retaining the risk and return profile of the Alerian MLP index—if not the yield.
The idea is to build a portfolio of MLPs that eliminates the extra layer of taxation, but in doing so can only hold 25 percent in traditional MLP LP interests, Baiocchi said.
One work-around used in EMLP is to own institutional share classes of MLPs that pay stock dividends. Another is what Global X did—including traditional equities engaged in similar businesses like pipelines or utilities, or owning the corporate share class of parent companies like Kinder Morgan.
“Make no mistake, these products are making their own trade-offs, namely diluting the classic MLP exposure in the portfolio, and in turn, diluting the tax benefits and yield of these portfolios,” Baiocchi said.
Quest For Yield
Whatever wrapper that’s favored, there’s no question that investors have increasingly embraced MLP ETFs and ETNs because they deliver solid dividend yields—a big draw for those looking for steady income outside of the compressed yields in fixed income.
The Federal Reserve’s monetary policies in the post-2008 credit crisis have fostered an environment of ultra-low rates, drying up traditional sources of income investors have long turned to over the years.
While investors fret over their allocation to fixed income, the MLP ETP segment has consistently delivered annualized income growth of about 7 percent, meaning investors see their income double every 10 years, according to data provided by Yorkville.
A simple asset class comparison shows that since 2000, an investment in the S'P 500 has returned about 50 percent, while MLPs have grown tenfold in the same period, Darren Schuringa of Yorkville said in a recent call. Yorkville is the sponsor of two MLP ETFs—the Yorkville High Income MLP ETF (YMLP) and the Yorkville High Income Infrastructure MLP ETF (YMLI).
The MLP’s attractiveness should remain strong as the market braces for higher rates ahead, Schuringa said, noting that historically, MLPs have performed well in environments of rising rates, or those periods of rising 10-year note rates for multiple consecutive quarters. In general, he said, MLPs have seen rates of return anywhere from 6 to 90 percent in previous periods of rising rates.
Going forward, many expect the segment to benefit not only in an environment of rising rates, but also to grow thanks largely to expanding investment in the U.S. energy infrastructure. More than $250 billion is expected to be invested in that space in the next 20 years.
MLPs are U.S. energy assets that were created in the mid-1980s by an act of Congress to encourage private investment in U.S. energy infrastructure, and have been used by many as safety investments, much like an allocation to U.S. Treasurys. A big part of that is that MLPs are known to deliver yields in excess of 6 percent, while yields on 10-year Treasury notes are still around just 2.6 percent.
Most, if not all, MLPs have toll-like revenues from things such as pipelines, meaning they aren’t affected by swings in oil and natural gas prices. The MLP class has grown at 25 percent rates in the past decade and now spans assets valued at $375 billion, according to estimates in the industry. Given expanding energy production in North America, that growth is likely to continue strongly, industry sources say.
“This is an asset class in growth mode,” Schuringa said.
The Right Strategic Fit For You
Choosing the right ETP in the MLP space requires some looking under the hood, because not all strategies are created equal, and as such, they can deliver vastly different returns.
Here is a quick look at the five largest MLP ETPs in the market today by assets, and how their performances so far in 2013 stack up.
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The Alerian MLP ETF (AMLP) is the most popular MLP ETP on the market, and the oldest that is structured as an ETF, boasting $6.75 billion in assets. The fund is structured as a C Corporation to allow it to allocate 100 percent of its portfolio to MLPs, but that means it faces a 35 percent corporate tax rate. At the end of the day, AMLP can’t pass through the full return of its underlying index to investors—its expense ratio is currently the highest in the segment at 4.85 percent.
Still, AMLP, which focuses on energy infrastructure, is delivering a dividend yield of 5.8 percent. Year-to-date, AMLP has tacked on gains of 15 percent, compared with the performance of the Alerian MLP Infrastructure Index, which is up 24 percent in the same period.
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The JP Morgan Alerian MLP ETN (AMJ) is the veteran in the space, and one of the most liquid, with some $5.7 billion in assets. While it was the pioneer in the space, AMJ is currently closed for creations, meaning it is essentially a closed-end note—one that is subject to big premiums and discounts.
AMJ, costing 0.85 percent, is shelling out a dividend yield of 4.6 percent. Year-to-date, its returns have reached 24 percent.
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The Morgan Stanley Cushing MLP High Income ETN (MLPY) invests in the highest-yielding MLPs in an equally weighted portfolio. The $2.5 billion strategy tracks the 25-name Cushing High Income MLP Index, but because it’s an ETN rather than an ETF, it does not offer the tax benefits of holding individual MLPs.
“The equal-weighted index does boost MLPY’s indicative yield above 7 percent, but since the issuer doesn’t actually hold any MLPs, the distributions it makes are merely coupon payments made to mimic the cash flow investors holding the index would receive,” an IndexUniverse ETF analytics report said. “These distributions are taxed as ordinary income, and any price appreciation is taxed as a capital gain.”
Costing 0.85 percent in fees, MLPY currently has a dividend yield of 8.37 percent. The ETN has seen year-to-date returns of 21 percent.
“The yield thrown off by the MLPs in the index is replicated with coupon payments on the ETN, which are taxed at ordinary income tax rates,” an IndexUniverse ETF analytics segment report pointed out.
Year-to-date, the $1.8 billion MLPI has seen gains of 9 percent, a far cry from the 24 percent jump in the Alerian MLP Infrastructure index. The strategy’s dividend yield is currently clocking in at 4.5 percent.
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The Credit Suisse Cushing 30 MLP ETN (MLPN) is an equally weighted portfolio of some 30 names that carries a bias toward small- and midcap names. Since the beginning of the year, the $616 million ETN, has shot up an impressive 25.7 percent while delivering a dividend yield of 4.6 percent. It too costs 0.85 percent a year.
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