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Should Income Investors Look at MLP ETFs as Inflation Spikes?

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Income focused investors are now looking for assets that can deliver high yields to counter inflation. Master Limited Partnerships (MLPs) represent an attractive investment option since in addition to juicy yields, they have relatively stable cash flows and solid growth potential. Further, they benefit from rising oil prices.

MLPs are publicly traded partnerships that are in involved in natural resource related activities. Most MLPs hold cash-generating assets and process or transport energy commodities under long term contracts.

They have relatively consistent cash flows, unlike exploration and production (E&P) companies, whose profits are highly correlated with commodity prices. As they do not pay taxes at the entity level, they have very attractive yields.

Further, MLPs have low correlations with many other asset classes including equities and commodities, and thus add diversification benefits to the portfolios.

MLPs come with complicated tax issues and many investors avoid investing in them only due to daunting tax requirements. They issue K-1s and further, since pipelines run through several states, investors may be required to file tax returns for all those states, in some cases.

Some of the tax complexities can be avoided by owning them in ETP form.  Payouts by ETPs are reported as ordinary income on Form 1099, and therefore K-1 forms are not required.

ETFs that have more than 25% of their assets invested in MLPs are treated as C-corporations for tax purposes. The additional layer of taxation results in tracking error. However, a significant portion of the distributions is tax-deferred. MLP ETFs are therefore more suitable for taxable accounts.

ETNs do not have any tracking error as they do not hold any securities. However, investors should remember than ETNs are unsecured debt instruments and carry credit risk. MLP ETNs are more suitable for tax-advantaged accounts as their distributions are taxed at ordinary income rates.

The Alerian MLP ETF (AMLP - Free Report) , the most product in the space, invests in energy infrastructure MLPs involved in midstream activities.  It is structured as a C-corporation and does not issue K-1s.

The JPMorgan Alerian MLP Index ETN (AMJ - Free Report) tracks an index comprised of midstream energy MLPs.  The Global X MLP ETF (MLPA - Free Report) invests in midstream pipelines and storage facilities. Also structured as a C-corporation, it is one of the cheapest ETFs in the space.

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