This Trap Took Your MLP Profits

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Exchange-traded funds promise simplicity in investing. Sometimes, though, they end up costing you a whole lot more than you expected.

Never has this been clearer than with one ETF that tracks one of the most lucrative dividend-paying sectors of the market. Below, I'll reveal that ETF's name and explain what went wrong. But first, let's take a closer look at the sector that this ETF focused on and some of the amazing investments that it tapped into.

The skinny on MLPs
Master limited partnerships were virtually unknown just a few short years ago. But with the boom in oil and gas production in recent years -- as well as oil prices that have jumped sharply over the past decade or so -- investors have increasingly turned to these energy-related investments for both growth prospects and healthy flows of income. Although you can find non-energy MLPs -- Terra Nitrogen (NYS: TNH) , for instance, is a fertilizer MLP -- most of them have ties to the energy industry.

MLPs have some big tax advantages that make them attractive to many investors. In particular, because MLPs are partnerships, they pay no income tax; instead, they pass on any taxable income directly to their shareholders, allowing them to avoid corporate-level tax. Moreover, because MLPs tend to generate more cash than their taxable income would suggest, the dividends that MLPs pay often don't create immediate tax liability for unitholders. And those dividends can be substantial: Inergy (NYS: NRGY) and Cheniere Energy Partners (ASE: CQP) have yields above 10%, while many more, including Linn Energy (NAS: LINE) , Kinder Morgan Energy Partners (NYS: KMP) , and Enterprise Products Partners (NYS: EPD) , pay 5% or more -- quite a bit more than major oil companies typically pay.

But one downside of MLPs is that the partnership structure requires a more sophisticated form of tax reporting for investors. Every year, MLPs send out tax statements called K-1s to their unitholders, and figuring out how to plug in income for tax purposes is much more challenging than regular stocks with their ordinary dividends.

A solution -- and a bigger problem
With that in mind, an ETF set out to solve the K-1 problem. Alerian MLP ETF (NYS: AMLP) owns a variety of MLPs, including the Kinder Morgan and Enterprise Products MLPs named above. By structuring itself as a corporation, the ETF ensured its shareholders don't have to deal with K-1s. But that convenience comes at a big cost: Unlike most ETFs, the Alerian ETF has to pay corporate tax on its taxable income.

But as a recent article in Barron's highlights, the impact of those taxes has apparently added up to big underperformance over the 15 months since the ETF began. While the benchmark that the fund tracks has risen more than 24% since August 2010, ETF shares have gone up less than 15%. Even with an expense ratio of 0.85% annually, the remainder of the fund's underperformance has apparently come from its added tax burden.

A close look at the ETF's prospectus reveals a possible explanation: In calculating its daily net asset value, the ETF has to take into account accrued deferred tax liabilities. As an Investor's Business Dailyarticle discussed earlier this year, the fund apparently does so by reducing daily price changes by 37.5%, reflecting the estimated impact of federal and state taxes. At least so far, the net impact to ETF shareholders has been huge.

In a nutshell, what this means is that in order to avoid the hassle of dealing with K-1s, you have to accept the full impact of corporate-level taxation on your investment. Given how much performance you have to give up, one has to question whether investing in the ETF truly makes sense.

Go straight to the source
ETFs can make your life easier, but only if they do things the way you expect. In this case, MLP investors would probably prefer to keep more of their money even if it means dealing with some extra tax forms. Unless the Alerian MLP ETF can figure out a more tax-efficient way of fulfilling its purpose, it's hard to recommend it as an alternative to buying individual MLPs directly.

With oil prices heading back toward $100, smart investors are positioning themselves to take advantage. MLPs aren't the only way to make money, though. Join the thousands of readers who've discovered the Motley Fool's picks to profit from the energy boom in our free special report, "3 Stocks for $100 Oil."

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time this article was published Fool contributor Dan Caplinger doesn't let anyone touch his profits. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy warns you about traps better than Admiral Ackbar.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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