Many have piled into master limited partnership exchange traded funds, enticed by prospects of higher yields. However, investors should take a step back and familiarize themselves with the investment before diving in head first.
In the first six months of 2013, master limited partnership related mutual funds and exchange traded products, which include both ETFs and exchange traded notes, have gathered $8 billion in new inflows, The Wall Street Journal reports.
The the largest MLP-related ETF, Alerian MP ETF (AMLP), has garnered $1.8 billion in net inflows year-to-date, according to IndexUniverse.
The rising interest in MLP assets is not surprising as MLPs have returned 16% annually over the decade ended July 31, compared to an annual average return of 7.6% in the S&P 500 index.
The widely observed Alerian MLP index, the underlying index of AMLP, shows a yield about 5.7%, whereas the benchmark yield on 10-year Treasuries is about 2.6% and the S&P 500 has a 1.97% yield. Additionally, many analysts anticipate MLP yields to rise as the U.S. energy boom continues.
However, analysts are now concerned that the rise in MLPs is driving up valuations and dampening the quality of offerings.
Looking at MLP fund investments, investors should also beware of costs. MLP mutual funds come with an average 1.44% annual expense while the average ETF has a 0.82% expense ratio. In comparison, traditional beta-index energy ETFs come with expense ratios as low as 0.14%.
While the payouts look attractive, MLP yields are vulnerable to rising interest rates. Companies that fund operations with debt will take on higher costs as rising rates translate to higher borrowing costs.
MLPs also come with their own set of tax rules. MLPs are partnerships, which "pass-through" net income to their "limited partners," or investors, so there isn't a corporate-level tax. However, individual MLPs come with K-1 forms due to their tax-deferred status, inability to deduct current losses against other income, and can trigger taxable income even in a tax-free individual retirement account (IRA).
Investors, though, can use MLP funds to circumvent some of the tax headaches - MLP funds come with 1099 tax reporting instead of the K-1 reports and don't generate taxable income in IRAs, but MLP ETFs and ETNs come with their own considerations.
Some MLP funds are structured as a C-corporation, which owe taxes on 35% on the holdings and are subtracted from the fund's net asset value. Consequently, some argue that MLP ETF overall expense ratios are closer to 5%, which has led to underperformance compared to their benchmark. For instance, AMLP is about 6% below its benchmark so far this year.
Nevertheless, ETF providers argue that these ETFs provide investors with a diversified portfolio of MLPs for investors who wouldn't be able to afford to spread out risk among a significant basket of MLP holdings.
Some non-C-corporation MLP ETF have reduced MLP holdings to under 25% to meet regulatory rules and hold other energy infrastructure stock through subsidiaries. Some examples include the Global X MLP & Energy Infrastructure ETF (MLPX) and actively managed First Trust North American Energy Infrastructure Fund (EMLP).
MLP ETNs, or unsecured debt instruments designed to replicate an MLP index, also come with 1099 forms, but the payouts are considered ordinary income, taxed at a 43.4% rate for top-bracket investors, plus state taxes. Additionally, as a debt instrument, the ETNs are subject to the credit worthiness of the underwriting bank. The JPMorgan Alerian MLP Index ETN (AMJ) is the largest MLP-related ETN.
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own AMLP.