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The Hidden Cost of Master Limited Partnership ETFs

Thursday - 2/14/2013, 6:24pm  ET

With the big decline in interest rates on traditional fixed-income investments over the past several years, investors have increasingly turned to specialty investment vehicles to provide the income they need from their investment portfolios. Master limited partnerships have grown greatly in popularity as a result, as their unique structure and tax advantages offer distribution yields that are among the most attractive in the financial markets right now.

But as MLPs have gotten more popular, Wall Street has sought to offer diversified exposure to the income-rich investments by creating exchange-traded products that own many different MLPs. Unfortunately, those products often come at a much higher cost than many investors understand.

Later in this article, I'll talk about how the brand-new Yorkville High Income Infrastucture MLP ETF uses the same structure that destroys many of the tax benefits of owning MLPs. First, though, let's take a look at why MLP investors have looked to ETFs as a way to avoid some of their complexities.

The hassles of MLPs
Master limited partnerships have become so popular because of their high yields, and the reason that their yields are so high is that the MLP structure qualifies for special tax treatment. Unlike most companies, which have to pay corporate-level taxes even before they distribute any remaining profits to their shareholders, MLPs benefit from their partnership structure and therefore don't have to pay tax at the entity level.

That tax advantage leaves MLPs more money to distribute to their unitholders. As an oversimplified example, Kinder Morgan Energy Partners  has Kinder Morgan as its general partner, with the latter being a corporation. While the Kinder Morgan corporation pays a dividend yield of about 4%, Kinder Morgan Energy Partners pays distributions yielding about 6%. Although the two entities don't have identical exposure, it gives you a flavor for the tax advantages the MLP structure gives investors.

Moreover, MLP distributions often include income that isn't fully taxable. Investors often get the benefit of depletion allowances, depreciation, and other favorable tax attributes from the energy businesses that are predominant in the MLP universe.

The problem, though, is that the partnership structure makes tax reporting for MLPs a lot more complicated than it is for regular stocks. Stock investors get simple 1099 forms that allow them to put single-line entries for their dividend income on their tax returns. By contrast, MLPs each issue partnership returns on Schedule K-1, requiring several different tax-form entries and sometimes even specialized tax forms that most investors never have to complete.

How ETFs simplify taxes -- at a price
The benefit of owning exchange-traded MLP products is that they avoid many of these tax complications. In particular, the Yorkville High Income MLP ETF and the pioneering ALPS Alerian MLP ETF both promise the convenience of 1099s rather than complex K-1 filings.

The problem comes from the way in which these ETFs achieve that goal. Unlike most ETFs, which are registered investment companies that are also exempt from having to pay fund-level taxes, these MLP ETFs are structured as regular C corporations.

The benefit of this structure is that it interposes a taxable entity between ETF shareholders and the MLPs that avoids investors having to deal with K-1s. The ETF has to handle the partnership tax issues, paying dividends to shareholders on regular 1099s.

There's a big trade-off, though. C-corporation ETFs have to pay corporate tax on their profits. In order to reflect their tax liability, MLP ETFs adjust their net asset values upward or downward on a daily basis. The new Yorkville ETF's prospectus doesn't state a specific percentage by which it adjusts for deferred tax liability, making the adjustments far less transparent to investors, but the older Yorkville High Income MLP fund computes taxes based on the current corporate tax rate of 35%.

The result is that MLP ETFs underperform the MLPs they own by roughly the percentage that goes to corporate-level taxes. Over the past several years, that has added up to huge shortfalls for the MLP ETFs with longer histories compared to the MLP indexes that these ETFs usually use as benchmarks.

Is the cost worth it?
Of course, for some investors, giving up more than a third of your prospective gains might seem worth it to avoid the tax hassles of owning MLPs directly. But exchange-traded note alternatives JPMorgan Alerian MLP ETN and UBS E-Tracs Alerian MLP ETN give investors a different way to avoid K-1s without the big drag on returns, albeit with the introduction of issuer credit risk from ETNs.

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