Another ETF Offers a Tax Break

Exchange-traded funds that invest in MLPs offer tax breaks as well as substantial yields. But notes may offer an even better break, along, however, with bank credit risk.

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Investors have another exchange-traded product to choose from that offers tax advantages, thanks to their investment in master limited partnerships or MLPs. The most recent entry is from Yorkville ETF Advisors, which launched the High Income MLP ETF late last month.

The only other ETF in this space that invests in energy MLPs is the ALPS Alerian MLP ETF (AMLP), from MLP indexer Alerian, based in Dallas, Texas. Like YMLP it also is listed on the New York Stock Exchange’s Arca trading system.

Yorkville’s ETF, which is also listed on the NYSE as YMLP, is designed to track the Solactive High Income MLP index. Structured Solutions, of Frankfurt, Germany, created the index and chooses the components and relative weightings of the securities. YMLP largely holds units in partnerships in industries within natural resources, such as timber, coal, fertilizer, oil and natural gas, and allocates no more than 4 percent to any one company. The index yields 8.8 percent, and the fund has an expense ratio of .82 percent. AMLP yields only 5.9 percent, and its expense ratio is 3 basis points higher than that of YMLP.

But ALMP’s yield may be more stable than YMLP’s, say analysts. That’s because the Alerian fund invests in partnership units of businesses in the transportation of petrol liquids, such as gasoline, oil and natural gas. Morningstar analyst Abraham Bailin explains that the commodity infrastructure business isn’t as volatile as the commodities it supports and in which YMLP invests. “The operating income from the transportation of fuels tends to be much less volatile than the prices of commodities themselves, where a marginal drop or spike in supplies or demand tend to cause prices to fluctuate wildly,” Bailin wrote in a recent report.

Darren Schuringa, managing partner at Yorkville ETF Advisors, disputes the contention that YMLP’s income is potentially unstable. “We’re in a diverse bunch of companies,” he says, and notes that the fund is looking into alternative energy. “We plan to evolve with the asset class,” says Schuringa.

Both funds exploit a tax break enacted by Congress in 1986 to spur investment in the transportation, storage and processing of natural resources. Today there are 86 MLPs with a combined market capitalization of $310 billion, compared with 29 with a market cap of $25 billion 10 years ago. These partnerships pay out virtually all their earnings and because the payouts are for the most part considered a return of capital, investors’ taxes can be deferred until they sell their shares. And then the tax is payable, as long as the investment is held for longer than one year, at the capital gains rate of 15 percent instead of ordinary income rates, which can run as high as 35 percent. However, like a mutual fund, MLP ETFs pay corporate taxes daily out of the fund’s pool of assets.

For that reason, Bailin states that, “We think MLP ETNs make more sense for some investors than owning MLPs outright or in the ETF or CEF wrapper.” Unlike ETFs, ETNs aren’t partnerships so they escape corporate taxation. To be sure, investors in the notes pay tax every year at ordinary income rates, but analysts say the benefits of avoiding corporate taxation of 35 percent outweigh the advantage of paying tax on their earnings at the 15 percent capital gains rate.

With an ETF, Bailin tells Institutional Investor, “you’re only getting 65 percent of the appreciation.”

One drawback to exchange-traded notes of all kinds is they are unsecured debt obligations of the banks that back them, so investors are subject to the banks’ credit risk.

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