How To Find The Best MLP ETF

By ETFDatabase | January 14, 2013 AAA

As an investment category, master limited partnerships (MLPs) have long been popular with investors who want to generate tax-advantaged income from their investments. These entities are generally built around natural resources (especially the transport of oil and/or gas), and in exchange for passing along a very high percentage of earnings to shareholders, they are given preferential tax treatment . Unfortunately, ownership of MLPs can significantly complicate an investor's tax returns, and there are always company-specific risks to consider. ETFs offer a real advantage because they not only diversify the risk, they also provide a simple Form 1099 to investors instead of a K-1. On the downside, MLP ETFs/ETNs are still relative newcomers to the market, and there aren't a lot of large or liquid options.


Price Drivers

Given that so many MLPs are built around midstream, storage or energy transportation businesses, it's not too surprising that the energy markets have a meaningful influence on these units. While some MLPs operate in regulated environments where prices are carefully controlled, others do not - in either case, changes in volume (often tied to the economic conditions of the region or country) can significantly impact anticipated distributions and unit prices.

MLPs also move on capital expansion plans and interest rates. Capital expansion generally means a larger asset base from which to generate future distributions, but often at the cost of higher interest payments and/or share dilution, as well as increased risk. Given that MLPs make extensive use of debt financing and are often seen as alternatives to bond investments, these units are also quite sensitive to interest rate moves.


Where They Fit

MLPs, and by extension MLP ETFs and ETNs, are typically seen as more conservative, income-oriented investment options. For example, the largest ETN by asset value, the JPMorgan Alerian MLP Index ETN , presently offers a 5% yield - more than double the yield of the S&P 500. Although undervalued MLPs can offer attractive capital gains, by and large MLP ETFs/ETNs are best suited for those more interested in steady income accumulation as opposed to capital gains. Although MLPs don't tend to be volatile on a day-to-day basis, they can move quite dramatically in response to new interest rate expectations or proposed changes to tax laws .


Factors To Consider

There aren't many MLP ETFs out there, but they are a pretty diverse bunch. The largest (AMJ, the JPMorgan Alerian MLP ETN) is designed to match the Alerian MLP Index and those returns are backed by the credit of JPMorgan (JPM). In exchange for that credit risk, there is better tax efficiency and no tracking error.

When choosing between these funds, consider whether you want an ETN (again, more credit risk, but no tracking error and better tax efficiency) or an ETF. Beyond that, the choices really revolve around whether you want a leveraged vehicle (increasing the risk, but also the return potential) or a fund that focuses more on higher-yielding, riskier MLPs.


The Contenders

In addition to the aforementioned JPMorgan ETN, there is an actual Alerian MLP ETF , which holds the stocks in the index. The Cushing 30 MLP Index ETN replicates a different index and is backed by Credit Suisse (CS), while the Yorkville High Income MLP ETF targets a wider, if riskier, set of MLPs in the search for higher yields. The E-Tracs 2x Leveraged Long Alerian MLP Index ETF uses that underlying Alerian index but adds leverage to magnify the returns.


People's Choice

The JPMorgan Alerian ETN (AMJ) and the Alerian MLP ETF (ALPS) are far and away the largest players in the market - the third-largest fund is one-tenth the size of Alerian MLP ETF. Volume is likewise strong for the two largest instruments, though the six largest funds all have adequate volume for most investors' needs .

As a reminder, these are relatively new offerings, with the oldest being only about two years old.


Expense Considerations

Although the net asset value of the two largest funds is pretty respectable, these are relatively expensive ETFs and ETNs. Five of the six largest funds have expense ratios of 0.85%, with the sixth charging 0.82%.


Depth + Balance

With 25 stocks in the Alerian MLP Index and 30 in the Cushing 30 Index, these are somewhat concentrated funds and notes by the standards of the broader market.


Unique Options

Investors considering these ETFs and ETNs ought to also consider a couple of closed-end funds. While closed-end funds have gone out of vogue with the rise of ETFs, they still have certain advantages including potentially superior (or inferior) performance from active management. Tortoise Capital Advisors offers a number of closed-end funds, including the Tortoise Energy Capital Corp (TYY). Kayne Anderson also offers closed-end alternatives, including the Kayne Anderson MLP Investment Company (KYN) .

Disclosure: Author owns shares of JPMorgan (JPM).

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