An ETF Alternative to Pesky MLPs

06/22/2012 7:45 am EST

Focus: ETFs

Genia Turanova

Editor, Leeb Income Performance

In concept, Master Limited Partnerships can be great vehicles for income-focused investors, but you have to work a little bit harder on your taxes. This exchange traded fund obviates the need for added tax stress, notes Genia Turanova of Leeb Income Performance.

The tax implications regarding master-limited-partnerships (MLPs) for many investors, institutional and retail alike, and the potential headaches, are enough to keep them away from these otherwise attractive income-generating investments.

Fortunately, an easy way to get around the tax complication issue also exists: invest in an MLP fund instead of individual MLPs.

The most popular fund available is the exchange traded fund Alerian MLP ETF (AMLP). The fund tracks the Alerian MLP Index, a capitalization-weighted composite of the 50 most prominent energy MLPs. The fund itself only has only 25 of the largest components in the index.

As of this writing, the largest MLP by market cap Enterprise Products Partners (EPD) occupies the top spot in the fund with roughly a 10% weighting, followed closely by Kinder Morgan Partners (KMP), the second-largest US MLP.

Our other energy MLP picks, Magellan Midstream Partners (MMP), El Paso Pipeline Partners (EPB), Targa Resources Partners (NGLS), and Spectra Energy Partners (SEP), are all represented in the fund. Penn Virginia Resource Partners (PVR) is in the underlying index, but too small to be included in the fund.

Beside the one-stop investment in the broad MLP space, the beauty of the fund is that it shoulders the tax issues of MLP-investing. Therefore, ETF shareholders don’t have to deal with the MLP tax-related issues. The fund can also be held in a tax-deferred account without potentially incurring taxes.

However, the drawback is that unlike most other funds, which don’t pay income taxes at the entity level, the fund does not qualify as a “regulated investment company” under current tax law (because of its investments in energy MLPs). Consequently, it is taxed as a corporation, resulting in the common “double-taxation” issue, as in a normal stock, potentially lowering actual returns.

Besides an ETF, a second alternative is an exchange traded note (or ETN). ETNs are actually debt securities, whose value is designed to track an underlying index. So investors are buying debt instead of a portfolio of stocks.

In the case of AMLP, the ETN counterpart is JPMorgan Alerian MLP Index ETN (AMJ). Note that the main difference is that there is issuer credit risk. In the case of AMJ, the fortunes are tied much closer to the fortunes of its issuer, in this case JPMorgan Chase (JPM).

We continue to recommend the individual MLPs in our High-Yield Income Portfolio, but the fund alternative is worth consideration for investors very concerned about the MLP tax complication. But as always, we recommend you consult with a tax professional to get advice on what makes more sense in your personal situation. Plus, a good idea is to familiarize yourself with the prospectus of an ETF/ETN before investing.

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