MLP ETF is Here: Finally!

ETNs are actually a form of debt issued by a sponsoring institution. In other words, when you buy an ETN you’re exposed to credit risk.

 – Elliott Gue, MLP Profits

Energy master limited partnerships (MLPs) continue their amazing run of outperformance vis a vis the S&P 500 index. Year to date, the total return of the Alerian MLP Index (NYSE: ^AMZ) is up 17.48% compared to a negative 4.27% return for the S&P:

Source: Bloomberg

This 21.75% outperformance so far in 2010 is on top of the best year in MLP history back in 2009, when the MLP index outperformed the S&P 500 by an astounding 50%!

Source: Bloomberg

No wonder I keep writing about MLPs! No wonder that this past June the biggest initial public offering (IPO) for a closed-end fund (CEF) in three years was an MLP fund. And no wonder MLP Profits, the investment service run by dividend expert Roger Conrad and energy expert Elliott Gue, is so popular with subscribers.

Advantages and Disadvantages of MLP Investment Options

Back in June, I wrote about three ways that you can own energy MLPs:

(1) individual MLPs like Enterprise Products Partners (NYSE: EPD);

(2) closed-end fund MLPs like Kayne Anderson MLP Investment Company (NYSE: KYN); and

(3) Exchange traded note (ETN) MLPs like JPMorgan MLP Index (NYSE: AMJ).

Each of these options has advantages and disadvantages:

In my June article, I didn’t mention an MLP ETF as an option because, well, none existed.

Until now . . .

MLP ETF is Here!

On August 25^th, Alerian, the company that manages the benchmark MLP index (NYSE: ^AMZ), announced the launch of the Alerian MLP ETF (NYSE: AMLP). Alerian President Kenny Feng stated:

The Alerian MLP ETF provides a single Form 1099, no K-1s, and allows investors to potentially benefit from return of capital and qualified dividend tax treatment of distributions. We believe this product is the answer to what the marketplace has demanded for years and represents a breakthrough in MLP investment.

I completely agree. For investors who want the instant diversification of an MLP fund, the only two previous alternatives — CEFs and ETNs — were seriously lacking for all of the reasons listed in the above table. In contrast, an MLP ETF solves almost all of the problems inherent in CEFs and ETNs. Most importantly, an MLP ETF does not suffer from the tracking error and premium-to-NAV problems of CEFs and does not suffer from the ordinary income taxation and credit default risk problems of ETNs.

Internet Misinformation

So I was shocked to read some guy named Ron Rowland trash the new MLP ETF on his website ironically named “Invest with an edge.” I think a much more accurate name for his website is “Invest with a 100-pound weight around your shoulders.” To his credit, Rowland admits that:

taxation of MLPs is a difficult subject, and I do not claim to know all the ins and outs.  I am not a tax advisor.

He should have stopped there and focused on something he understands. But instead he goes on to argue that an MLP ETF is inferior to an MLP ETN!  Why? Because he doesn’t like the fact that an MLP ETF must pay corporate income tax at the fund level whereas an MLP ETN – such as UBS E-TRACS Alerian MLP Infrastructure Index ETN (NYSE: MLPI) — does not:

AMLP will be taxed as a corporation and the NAV will reflect a 35% withholding for taxes while MLPI will not.

Not Telling the Whole Story

That’s true. But he ignores the fact that the corporate tax applies only to the income the MLP ETF receives from its MLP investments, not to the entire cash distribution it receives. This is an important point because 80% to 90% of an MLP’s cash distribution is not considered income but a tax-deferred return of capital. Consequently, the 35% corporate tax Rowland is so worried about only applies to 10% to 20% of the cash the MLP ETF collects. This same 10% to 20% will also be taxable at the shareholder level (just as it would be for unit holders of individual MLPs), but the MLP ETF prospectus (p. 13) says that the shareholder tax rate could be the lower qualified dividend tax rate of 15%, not the higher ordinary income tax rate, if the ETF shares are held for more than 60 days.

(note: there is a chance that the 15% qualified dividend tax rate will end in 2011. Roger Conrad, co-editor of MLP Profits, recently wrote an article urging income investors to visit www.DefendMyDividend.org and sign the petition to maintain preferential dividend tax rates).

In contrast, Rowland completely ignores the much more important tax disadvantage of MLP ETNs: 100% of the cash distributions received by investors are taxed at ordinary income tax rates of up to 35%! (note: the top ordinary income tax rate will likely rise to 39.6% in 2011).

Elliott Gue, co-editor of MLP Profits, understands the tax treatment of MLPs better than anyone (except maybe co-advisor Roger Conrad) and pointed out this salient fact recently to his subscribers when he wrote:

Because these MLP products are ETNs, the income you receive is ordinary income, NOT qualified dividends or partnership distributions. You won’t receive any of the income-tax deferral benefits associated with owning individual MLPs.

So, I ask you, which is worse: a 35% corporate tax rate on 10%-20% of cash distributions and shareholders paying a qualified dividend tax rate of 15% on 10%-20% of cash distributions, or a zero corporate tax rate and shareholders paying up to a 39.6% ordinary income tax rate on 100% of cash distributions? I’ll answer this rhetorical question: paying ordinary income tax on 100% of cash distributions is much, much worse.

If the MLP investment is held in a retirement account, Rowland’s argument in favor of ETNs has more merit because shareholder-level taxes are deferred or, in the case of a Roth IRA, eliminated. But even in this case, we’re talking only about at most a 7% cash haircut at the ETF level (35% of 20%) and Rowland completely ignores the credit default risk inherent in ETNs. Aaargh!

Don’t Listen to Parrots Either

I wouldn’t be so steamed about this Rowland guy except other writers are quoting him as some sort of MLP expert. Take, for example, a “contributor” to thestreet.com named Roger Nusbaum who parrots Rowland’s misleading tax information.

I also am irritated that Nusbaum falls into the trap of thinking MLPs are risky simply because they have performed so well recently:

This pattern of a segment doing well, followed by investor demand, followed by products created to meet demand, has happened many times in the past, and usually the next steps are bad: Supply exceeds demand, prices go down.

Does Nusbaum truly believe that the prices of MLPs will go down even if their underlying businesses remain strong and their distributions continue to grow? Basing investment advice on a sense of irony instead of analyzing valuation is unwise.

Listen to an MLP Expert

In a well-researched article dated August 24^th and entitled “Extremes in Sentiment, Not Valuation,” Elliott Gue, co-editor of MLP Profits, advised subscribers to focus on valuation, not perceived sentiment: “just because MLPs have performed well doesn’t mean they’re overvalued.” 

Mr. Gue then analyzed the current spread between MLP yields and other income investments such as corporate bonds and real estate investment trusts (REITs) and compared it to historical averages. Elliott’s conclusion: MLP yield spreads are higher than average, suggesting that MLPs remain reasonably valued despite their recent outperformance.

Bottom Line

To sum up, I’m very happy that an MLP ETF is finally available and you should be too. For those investors who want diversified MLP exposure in their taxable account, an MLP ETF will beat the pants off of an MLP ETN every time.

As I wrote in July, however, the absolute best solution is to manage your own portfolio of individual MLPs with the guidance of MLP Profits. You get maximum tax benefits and focus on only the best MLPs instead of being forced to invest in the index’s mediocre and bad ones. But maybe that’s just me.