A quirky and complex investment class called master limited partnerships has been one of the market's best performers of late. The widely followed Alerian MLP index of 50 energy MLPs returned 14% in 2011, including dividends, versus 2.1% for the Standard & Poor's 500-stock index.
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While MLPs can be risky, there is reason to believe they still hold appeal.
MLPs are partnerships that trade like stocks and pass their income directly to investors.
The yields, paid in the form of "distributions" rather than dividends, can be juicy. The Alerian index yields about 6%--triple that of the S&P 500 and about double what investors can get from 10-year, A-rated corporate bonds.
While the income from MLPs is taxable at rates up to 35%, investors often can defer taxes on the bulk of it. That is because MLPs distribute not only cash income but also paper write-offs for their asset depreciation. Investors pay current taxes only on the income that exceeds depreciation. The rest--often 80% or more of the total--serves to reduce the investor's "cost basis," and is taxed only when the investment is sold.
Regular dividends, by contrast, are taxed in the year they are received, currently at a top rate of 15%.
MLPs have their complications. Some, such as pipeline MLPs, can draw income from many different states. A wealthy investor with a portfolio of MLPs can end up having to fill out many extra forms.
Also, MLP positions held in retirement accounts can produce something called "unrelated business taxable income." Large amounts of that can require investors to file additional tax returns and make extra payments.
There are fewer than 100 MLPs that trade on major exchanges, and together they have a stock-market value smaller than that of Exxon Mobil (XOM) . Many operate in the stable "midstream" part of the energy business, merely collecting a toll for transporting and storing oil and gas. That typically is steadier than exploration or refining operations.
John Edwards, an analyst at investment bank Morgan Keegan, estimates that the amount that MLPs will pay to investors as income will rise 5% to 8% this year. With investors having snapped up many of the larger MLPs last year, he thinks the best opportunities lie in smaller players. Among them: EV Energy Partners (EVEP), which yields 4.6%; Crosstex Energy (XTEX), 7.6%; and Genesis Energy (GEL), 6.3%. He predicts that each of these three will offer double-digit total returns over the next 12 months.
Jerry Swank, founder of Swank Capital, an MLP investment firm, favors players in the natural-gas-liquids business. He likes Enterprise Products Partners (EPD), which yields 5.1%; Oneok (OKE) (an MLP-owning corporation), 2.9%; and Targa Resources Partners (NGLS), 6.1%. Even though natural-gas prices are slumping, drilling for gas also yields valuable liquids such as butane and propane. That keeps production high, says Mr. Swank.
MLPs come with risks. Because they often borrow money to pay for new projects, a sharp rise in interest rates could eat into their income.
The biggest threat might be a plunge in energy prices, which could lead to less demand for pipeline services. But as this column discussed a month ago, U.S. production is booming as new technologies unlock vast deposits of oil and gas trapped in porous shale, and oil prices remain strong.
There are pros and cons for investors looking for MLP exposure via mutual funds. The pros: Funds provide easy diversification without requiring extra paperwork come tax time, even in retirement accounts.
The cons vary by vehicle. Exchange-traded notes like JP Morgan Alerian MLP Index (AMJ) (annual expenses: 0.85%) use derivatives to mimic MLP performance. But investors must pay regular taxes on the income they receive, and because the notes are issued by financial firms, investors could lose if the issuer goes belly up.
Exchange-traded funds, such as Alerian MLP (AMLP) (also 0.85% in expenses), preserve the tax breaks on income, but must themselves pay corporate taxes--a drag on returns in good years. In 2011, while the underlying index returned 17%, the ETF returned 10%. (When the index falls, the ETF does better because its tax bill shrinks.)
Traditional mutual funds like Cushing MLP Premier and Steelpath MLP Income have upfront sales charges that can top 5%, on top of ongoing expenses. Kinder Morgan Management (KMR) and Enbridge Energy Management (EEQ) are what is known as I-shares. They distribute shares rather than cash, so investors don't get spendable income, but pay taxes only when they sell.
Sure, MLPs are high-maintenance, but for many investors they are worth the bother. If getting a tax-advantaged 6% in income were simple these days, the opportunity probably wouldn't last for long.
—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com
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