MLPs Might Be Cheap, but This MLP ETF Is One to Avoid

If you're a contrarian investor, there's a pretty good chance you're taking a hard look at the master limited partnership sector right now. You aren't alone. A couple of the best investors in the business have been buying some MLPs.

When an entire sector is as beaten-down as MLPs, a good approach is to spread your bet across many companies in the sector by purchasing an ETF. That way you don't take on as much company-specific risk, but you still get to profit from a rebound.

After learning some of the issues with owning MLP ETFs, you probably will want to reconsider.

Beating the market is hard enough with a 5.49% haircut off the top

Source: alpsfunds.com.

The Alerian MLP Exchange Traded Fund (NYSEMKT: AMLP) markets itself as delivering exposure to the Alerian MLP Infrastructure Index, a capped, float-adjusted, capitalization-weighted composite of energy infrastructure MLPs that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities.

Whew. You need to take a breath after that sentence.

As of Feb. 25, 2016, here are the MLPs that the Alerian MLP ETF held:

I wouldn't mind owning those particular MLPs at those weightings for the next two years. I would mind owning them through this ETF, though.

The appeal of the MLP structure is its tax benefit. It eliminates double taxation. For a normal corporation, profits are taxed first at the corporate level and then again at the personal level if an individual shareholder receives a dividend. MLPs are considered to be "pass through" vehicles that can let their income flow through to shareholders untaxed. Therefore, the profits are only taxed at the individual shareholder level. The MLP itself does not pay income tax.

That tax benefit doesn't exist when the MLP is owned by an ETF, which is not an individual but instead a corporation itself. When a corporation receives a distribution from an MLP, it is required to paycorporate income taxes, typically 35%.Then after paying those taxes, any distribution from the ETF to its shareholder is taxed again as a regular dividend.

An ETF could choose to keep the status of investment-company and thereby be a pass-through entity. However, if it did it would be required to issue K-1s which would eliminate the appeal of the ETF to investors.

Because of the tax rules for MLPs, owning an ETF is not a great option. Investors would be far better off owning a basket of MLPs directly than they would be owning an MLP ETF.

You've Gotta Read The Fine Print

If you own the MLPs through the ETF, you're losing 35% of the yield you could receive by owning the same MLPs directly. Investors are surprisingly blind to this, because the tax at the ETF level shows up as part of the expense ratio, not as a reduction in the ETF's yield. That's why AMLP's expense ratio is a whopping 5.43%.

Investing is hard enough. By giving away over 5% off the top, it becomes that much harder. The bottom line is that if you want to own a basket of MLPs, you're going to want to own them directly and not through an ETF.

The article MLPs Might Be Cheap, but This MLP ETF Is One to Avoid originally appeared on Fool.com.

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