Tags: MLPs | ETFs | ETNs | pros | cons

The Pros and Cons of Investing in ETFs, ETNs for MLPs

By    |   Thursday, 26 April 2012 07:27 AM

Many investors are interested in master limited partnerships (MLPs) for their juicy income streams and their safety compared to other high-yield investments.

But MLPs carry a major hassle – K-1 tax forms that you must fill out each year. Investors now have MLP investment options to bypass K1 forms – exchange-traded funds (ETFs) and exchange-traded notes (ETNs).

ETFs are structured as corporations and ETNs are structured as bonds.

For those of you who are unfamiliar with MLPs, here’s a quick primer. Most MLPs are in the oil and natural gas business – pipelines, storage and processing.

“You’re generally gaining exposure to the energy sector without the typical price volatility which comes with owning the underlying commodities such as oil and natural gas,” Michael Sheldon, chief market strategist at RDM Financial Group, tells Moneynews.

MLPs are contractually required to pay a quarterly dividend. Many now yield more than 6 percent, which is much higher than most other investments that offer some safety.

Like other limited partnerships, MLPs benefit from the absence of double taxation. Most companies must pay corporate income taxes, and then shareholders pay taxes on dividends too.

MLPs pay no taxes at the corporate level.

But as an investor, you have to pay taxes using a K-1 form. "A K-1 from an oil or gas investment can be quite complicated," says Richard Rampell, CEO of Rampell & Rampell accounting firm, tells Bankrate.com. If you have an accountant, it will generally cost you $100 to $500 for each K-1, he says.

ETFs and ETNs help you avoid those forms. They also provide automatic diversification, as they are based on an index of MLPs, with the Alerian MLP Index being the most prominent.

But both investment types have downsides too. For ETFs, it’s a tax problem. While you don’t have to worry about K-1s, the ETF has to pay corporate taxes. Those tax payments are reflected by a decrease in the fund’s net asset value, which means a decrease in your returns.

Since the August 2010 inception of the ALPS Alerian MLP Index ETF, it has returned 13 percent, compared to 21 percent for the Alerian Index, according to Dan Caplinger of The Motley Fool. That’s quite a lost opportunity just to avoid K-1 forms.

ETNs don’t create that disadvantage, but they are structured notes, which means you are dependent on the financial health of the issuer, just as you are for a regular bond.

JPMorgan Chase is the issuer of the most prominent ETN for MLPs — JPMorgan Alerian MLP Index ETN. JPMorgan may be the safest bank in the country, so the risk is certainly low, but it’s there.

The other thing to remember about any form of investment in MLPs is that they’ve had an amazing run over the past three years, with an annualized return of 36 percent for the Alerian Index. That would indicate that a substantial correction is likely at some point.

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Thursday, 26 April 2012 07:27 AM
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