The Hidden Cost of Master Limited Partnership ETFs: Kinder Morgan Inc (KMI) and More

How ETFs simplify taxes -- at a price The benefit of owning exchange-traded MLP products is that they avoid many of these tax complications. In particular, the Yorkville High Income MLP ETF and the pioneering Alerian Mlp (NYSEARCA:AMLP) both promise the convenience of 1099s rather than complex K-1 filings.

The problem comes from the way in which these ETFs achieve that goal. Unlike most ETFs, which are registered investment companies that are also exempt from having to pay fund-level taxes, these MLP ETFs are structured as regular C corporations.

The benefit of this structure is that it interposes a taxable entity between ETF shareholders and the MLPs that avoids investors having to deal with K-1s. The ETF has to handle the partnership tax issues, paying dividends to shareholders on regular 1099s.

There's a big trade-off, though. C-corporation ETFs have to pay corporate tax on their profits. In order to reflect their tax liability, MLP ETFs adjust their net asset values upward or downward on a daily basis. The new Yorkville ETF's prospectus doesn't state a specific percentage by which it adjusts for deferred tax liability, making the adjustments far less transparent to investors, but the older Yorkville High Income MLP fund computes taxes based on the current corporate tax rate of 35%.

The result is that MLP ETFs underperform the MLPs they own by roughly the percentage that goes to corporate-level taxes. Over the past several years, that has added up to huge shortfalls for the MLP ETFs with longer histories compared to the MLP indexes that these ETFs usually use as benchmarks.

Is the cost worth it?

Of course, for some investors, giving up more than a third of your prospective gains might seem worth it to avoid the tax hassles of owning MLPs directly. But exchange-traded note alternatives JP Morgan Alerian MLP ETN (NYSEARCA:AMJ) and UBS E-Tracs Alerian MLP ETN give investors a different way to avoid K-1s without the big drag on returns, albeit with the introduction of issuer credit risk from ETNs.

In the end, you have to decide whether the cost of MLP ETFs is worth the benefit. To make a smart decision, you have to take all the costs into account, including returns lost to taxes.

The article The Hidden Cost of Master Limited Partnership ETFs originally appeared on Fool.com and is written by Dan Caplinger.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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