MLP ETNs vs. MLP ETFs

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"Declaring one as universally superior is misleading to investors."

For investors interested in MLP exposure, there are potential advantages in both the ETF and ETN structures. ETNs eliminate tracking error; as debt securities, their performance is linked to that of an index. And if the underlying MLP securities appreciate significantly in value, the ETN structure may be more tax efficient than a similar ETF due to the preservation of effective pass-through status for investors.

Conversely, ETFs are not debt instruments and are not subject to the issuer's credit risk. While some investors gloss over the risk of default associated with ETNs, the fate of those who held Lehman ETNs in 2008 serves as a cautionary tale. Moreover, for investors focusing on after-tax yield, the treatment of distributions is generally more favorable (from a tax perspective) under the ETF structure. If the underlying MLP securities depreciate or stay relatively flat, the advantageous tax treatment of distributions will offset any potential drawbacks related to the creation of a deferred tax asset or liability.

It's also worth noting that there is some risk to the current tax treatment of MLP ETNs. MLPs generate unrelated business taxable income ("UBTI"), which is why investors generally don't hold MLPs in a tax-deferred account. Under current tax law, ETNs linked to MLP indexes are treated as if they do not generate UBTI, but the IRS hasn't issued a formal opinion on this somewhat gray area of the code. That's not to say that a crackdown is coming, but it's certainly a possibility.

So there are potential benefits and drawbacks to both the ETF and ETN structure, and declaring one as universally superior is misleading to investors. "There are different markets for different investors," says Kenny Feng, president and CEO of Alerian. "Alerian's objective is providing information and product access to the MLP space."

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