New Small-Cap MLP Fund Offers Potential for Yield, Growth

NEW YORK TheStreet -- In the last couple of years there has been a flurry of exchange-traded products covering the master limited partnerships, or MLPs, with all of the funds so far having slightly different weightings of the same relatively large MLPs.

MLPs often provide infrastructure that allows oil and gas to get from one place (where it is taken out of the ground) to where it can be processed for consumption (like refineries) and collects what amounts to a toll.

The new Global X Junior MLP ETF ( MLPJ) hopes to separate from the pack by offering small-cap MLP exposure. The Global X literature promoting the fund points to IEA estimates about increased oil and gas production in the U.S. benefitting MLPs in general, and increased production in the Bakken benefitting the small caps in particular, as the catalyst to buy MLPJ because exploration is more likely to involve smaller companies, even for transportation.

The methodology for the underlying index' construction calls for companies with market caps of $2.5 billion or less. The largest holdings in the fund are Suburban Propane Partners ( SPH)6.77%, Northern Tier Energy ( NTI)6.61% and Alliance Resource Partners ( ARLP). The fund has 25 holdings in all and charges a 0.75% expense ratio.

The fund will issue a 1099 tax form instead of a K-1 form for unrelated business taxable income or UBTI. This will come as a relief to MLPJ fund holders for not having to do extra work when doing their taxes.

The taxation downside to the fund was isolated by blogger Ron Rowland, who has gleaned from the prospectus that "the Fund's accrued deferred tax liability will be reflected each day in the Fund's net asset value per share" and that the tax will be calculated at a 35% rate, which Rowland says will cause a large tracking error between the fund and its underlying index.

There is an unquantifiable risk to investing in the space in the form of changes to the tax treatment of MLPs. Late last year, MLPs collectively sold off in the wake of "fiscal cliff" uncertainty with the fear being that the manner they are taxed could be changed.

Despite the complexity, MLPs receive favorable tax treatment and so any changes in their favorable taxation would likely hit the group hard. In 2006 it was announced the tax treatment of Canadian Royalty Trusts would become less favorable and the group got crushed. The CanRoys, as they are called, are a close enough cousin to MLPs to set a reasonable expectation should their tax status change as well.

A more tangible risk to the MLP space is the recent flurry of IPOs. CNBC's Bob Pisani reported that of 44 IPOs since September, seven of them have been MLPs. Demand for MLPs and funds that own MLPs is hot and, in a pattern repeated many times before, the investment industry is creating more supply to meet the demand. The risk is that too much supply is created and prices go down.

For now, though, investors need yield and the market is not saturated now with MLPs, which makes for a continued favorable backdrop for the segment.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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