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Don’t Let This ETF Trap Snare You

Yesterday, we took a quick look at master limited partnerships (MLPs).

Well, like anything else, MLPs have their own exchange-traded funds (ETFs). Like their peers, which mimic the performances of indices, commodities and sectors, these ETFs seek to replicate the performance of the high-flying MLP market.

But if you’re thinking about investing in one of these funds for broader exposure, there are some key, and very costly, differences.

For example:

  • There are no tax advantages.
  • There are hidden fees.
  • And they have deceptive and costly structures.

I’ll explain…

The Hidden Costs of MLP ETFs

As I discussed in my previous article, MLPs offer some nice tax treatments – specifically, the distributions are considered a return of capital, rather than dividends, until you’ve earned back your original investment.

With an MLP ETF, however, the tax advantages of being a partner in an individual MLP disappear. Distributions are treated as dividends, not as a return of capital, and they’re taxed accordingly.

Another thing to consider is an ETF’s expense ratio – how much the fund itself is going to charge you for managing the ETF.

Of the 17 cheapest MLP ETFs on the market, expenses can range from a low of 0.45% up to 0.85%. Anything higher than that becomes too expensive, in my opinion.

And finally, the way the ETF is structured could really affect the money you receive as an investor.

ETFs can be structured in one of two ways: either as a regulated investment company (RIC), or as a “C corporation.”

ETFs that are C corporations have additional tax problems.

As a corporation, distributions are subject to double taxation – once at the corporate level, and again at the investor level.

The additional tax burden is passed on to investors as “additional expenses” and can take a serious bite out of the amount of money you’re actually paid.

Even worse, this tax burden isn’t included in the calculated expense ratio – meaning that, as an investor, you could get blindsided big time by this hidden “expense.”

For instance, the ALPS Alerian MLP ETF (AMLP), the most popular ETF in the field, is structured as a C corporation.

And though it boasts a decent, if somewhat pricey, expense ratio of 0.85%, its annual operating expenses are closer to 5% because it’s a C corp.

That’s a lot more than 0.85%.

ETFs that are structured as RICs, on the other hand, don’t have that additional tax bite taken out of distributions.

The Cheapest ETF on the Market

That said, if you’re going to pursue MLP ETFs, then you might consider the Global X MLP & Energy Infrastructure ETF (MLPX).

MLPX is designed to track the Solactive MLP & Energy Infrastructure Index – considered a benchmark for the midstream infrastructure sector. It encompasses midstream energy infrastructure MLPs and corporations – pipelines, storage facilities, transportation, and crude and natural gas processors.

Notice the description includes not just MLPs – but also corporations.

See, in return for the better tax treatment, ETFs formed as RICs are limited in their exposure. In fact, no RIC can hold more than 25% of its holdings in actual MLPs.

So the other 75% is made up of actual shares of pure-play infrastructure companies, as well as what’s known as “MLP affiliates” – owners of MLP general partner interests (the general partner is the one that runs the business, limited partners are the unit holders).

Though the number of actual MLPs that MLPX can hold is limited, the actual companies it owns are some of the top companies in the sector. Its top three holdings are Enbridge Inc. (ENB), Kinder Morgan Inc. (KMI) and TransCanada Corp. (TRP).

As you might be able to tell from the top three, MLPX is heavily weighted in the natural gas pipeline sector. In fact, 75% of its holdings are in natural gas. The remaining 25% are in oil pipelines.

With MLPX, you get exposure and pass through distributions from the MLPs. It’s also an RIC, so it doesn’t have the big corporate tax bite. You get the potential for capital gains from the underlying securities – and the 0.45% expense ratio is all you’ll ever pay to be a unit holder. No additional tax burden.

Furthermore, your tax planning is made much simpler, since you’ll receive a regular 1099, instead of a K-1 partnership form.

But don’t jump into MLPX right away. It’s a brand-new entity in a crowded field.

You might want to keep an eye on it, to see how it performs out of the gate, before investing any hard-earned capital.

And “the chase” continues,

Tim Diering