By
Morningstar
:
By Abby Woodham
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.
JPMorgan Alerian MLP Index ETN(
AMJ
) is not only the largest MLP product with more than $5 billion in
assets, but also the single largest ETN on the market. Its ETN
structure promises near-perfect tracking of the Alerian MLP Index
with a 0.85% expense ratio, which is standard. However, investors
are getting something different. As Sam Lee
illuminated in a great piece on path-dependent
fees
, ETNs are ripe for opaque pricing. AMJ's fee structure charges its
expenses on the ratio of the volume weighted average price ((VWAP))
level to the level at the fund's inception. For investors, this
means that in down periods, they could get charged more than 0.85%.
Dividends paid out by AMJ do not preserve the tax schedule of MLPs,
so the tax benefit of direct MLP ownership is largely diluted.
Additionally, parent JPMorgan Chase halted the issuance of new
notes, making this ETN functionally a closed-end fund that can
trade at a premium. New investors could be burned badly if they buy
AMJ at a premium that subsequently collapses. As with closed end
funds,
use a limit order
.
ALPS Alerian MLP ETF(
AMLP
) is on even shakier ground. As the first MLP ETF (as opposed to a
note), the fund has attracted investors with ease and now stands at
almost $4 billion. Because the Investment Company Act of 1940
forbids open-end funds from owning more than 25% of their portfolio
in MLPs, AMLP is structured as a C-corporation and pays income tax
at the corporate level. Any taxable income they receive from the
underlying MLPs is an annual tax liability, and upon the sale of
the portfolio's shares, they must also pay up at the corporate
level. Functionally, investors are being taxed twice. AMLP accounts
for these tax liabilities in the NAV, meaning that the total return
of the fund can trail the index by a massive 5%-6% annually. This
is a shame, because the concentrated index AMLP tracks has
outperformed the broader index of AMJ. AMLP charges a management
fee of 0.85% annually, the same as AMJ's. However, because of the
tax situation discussed above, its actual gross expense ratio is a
staggering 4.86%. After taxes, AMLP is one of the most expensive
ETPs on the market.
So what should investors do? Comparing the total return of the
two funds is illuminating.
(click to enlarge)
Source: Morningstar Analysts
Despite its flaws, AMJ is the pick of the litter for MLP ETPs.
As long as investors avoid buying at a premium, AMJ is the largest
and most liquid option out there. AMLP is a possibility for deeply
risk-averse investors, because its tax disadvantage becomes a boon
in down periods. AMLP captures significantly less upside than does
AMJ, but because some of its losses can be written off using
deferred tax assets, it will also capture less downside. As shown
above, in up periods AMJ quickly outpaces AMLP, but during down
periods, such as the fall of 2011, AMLP takes fewer losses.
However, we would expect AMLP to fall in line with AMJ if the
fund's cost basis drops below zero as discussed above. Those
willing to sacrifice a significant portion of positive return in
exchange for downside protection will like AMLP as long as this
threshold is not breached.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
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on seekingalpha.com