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MLP ETFs and ETNs: High Income, But Beware of Fine Print

Exchange-traded products give investors broad access to this desirable asset class, but resulting structural complications require close examination.

Morningstar Analysts, 09/07/2012

There’s a lot to like about master limited partnerships: high yield, the possibility of capital appreciation, diversification benefits, and lower volatility than the S&P 500. Huge inflows to the space this year have indicated a high level of investor interest. However, MLPs are also an unusually complicated asset class with a bevy of investment options in the exchange-traded space. Making a good choice on whether to invest in MLPs through exchange-traded products (or at all) is dependent on a solid understanding of the asset class, its taxation, and the implications of each vehicle.

First, let’s review what MLPs are and what benefits they have to offer. We'll then review the two most popular MLP exchange-traded products.

Wellsprings of Income
MLPs are focused in the “midstream” energy sector, meaning the processing and transportation of energy commodities. These companies own and operate the pipelines that deliver gas and liquids across the country, as well as the storage facilities and processing plants that bring product to market. They charge fees based on volume, not volatile commodity prices, so although MLPs are in the energy sector, their revenues are remarkably consistent. The legal structure of MLPs means that at least 90% of income is passed on to investors, but this also means that they must borrow money to finance new projects. As long as interest rates remain low, MLPs will be able to cheaply finance new projects and grow.

Traditionally only in the portfolios of income seekers, these hybrid vehicles have been attracting more progressive investors lately. As of the end of July, the Alerian MLP index was earning a 478 basis point yield spread over 10-year Treasuries and solidly trouncing utilities and REITs. While MLPs might not get the yield of preferred stock, they can still benefit from the growth of the issuing company: MLPs have enjoyed over 10% price return annualized since 2010 and have far less uncertainty about their future than preferred stock does. Income-seeking or not, it is hard to deny that the yield is attractive, both from income and total return perspectives.

Don’t forget that unlike REITs, MLPs have also retained their diversification benefits. While MLPs have experienced an increase in correlation with the market recently, they are still less stocklike than most other income-generating assets sans bonds. During the financial crisis MLP correlation with the market spiked, but remember: In periods of extreme volatility, market correlation goes up across the board. MLPs suffered less than most sectors and the increased correlation dropped off toward the end of 2008.

MLP investors should be somewhat bullish on the energy sector, as they are still tied to the industry’s health to some degree. When natural gas production and demand rise, so do the fortunes of MLPs. Conversely, a decrease in demand is the biggest risk to the sector. Luckily, the future looks bright on this count: The U.S. produces more natural gas than any other country in the world and production grew by a healthy 7.7% last year. Worldwide natural gas consumption went up by 2.2% in 2011, despite significant declines in consumption in the EU. Gains in China were particularly robust, as demand increased by 21.5%. The domestic MLP market is well-placed to capitalize on further production growth. For the most part, MLP investors can ignore the price of underlying commodities. Demand for gasoline and natural gas is fairly inelastic, meaning that the volume of product consumed does not fluctuate nearly as violently as the underlying prices.

Tax Treatment: Pluses and Minuses
Individual investors and institutions have been off-put by the unusual and complex tax treatment of MLPs. Come tax season, owners will receive a complicated K-1 form instead of the usual 1099, and they may have to file in every state the MLP operates in. Those paying for tax services “by the pound” may find the excess return of MLPs wiped out by costs. My colleague Christine Benz has written about owning MLPs in a retirement account, finding that the costs far outweigh the benefits. In particular, retirement accounts can actually, though rarely, become taxable because of unrelated business taxable income (UBTI) accrued by MLPs.

Despite high administrative costs in tax season, MLP ownership has great tax benefits. Dividends from MLPs are tax-deferred, so they function as income today, tax later. Retirees, this structure has your name all over it. Let’s break it down: The income MLPs pay out isn’t a dividend, but rather a distribution. When an MLP pays out a distribution to investors, the lion’s share is treated as return of capital and is not taxed immediately. Instead, it is subtracted from the owner’s cost basis. Then, when the investors sell shares, they pay ordinary income tax on the difference between the reduced tax basis and the original tax basis, plus capital gains tax on the capital appreciation of the stock. Essentially, the investor is able to defer paying taxes on distributions until they sell their shares. If the owner holds the MLP so long that the reduced tax basis reaches zero, any further basis reductions from distributions will be automatically taxed as a long-term capital gain. For retirees or any other investor looking for income today with a favorable tax schedule, it doesn't get much better than this.

Popular Doesn't Mean Perfect
With more than $3 billion flowing into the two largest exchange-traded MLP products this year alone, it’s clear that the market is hungry for this complicated asset class. The main benefits to buying MLPs in an exchange-traded wrapper are diversification in a box and an easing of the tax headache: Returns will be filed on a 1099, doing away with K-1s. Owning these ETPs in a retirement account won’t induce UBTI taxes either. Unfortunately, these same two popular products have their own notable drawbacks.

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