Since the end of 2007, the Alerian MLP Index has generated a total return of 76.5 percent, about 75 percent of which came from price appreciation. The S&P 500, on the other hand, lost 2 percent over the same period. This outperformance reflects strong fundamentals, but you can't rule out market psychology and demographics when making the investment case for master limited partnerships (MLPs).
Many income-seeking investors also remain scarred by the stock market implosion that accompanied the global credit crunch and Great Recession. Few will forget the panic that ensued when corporate titans such as General Electric (NYSE:GE) and Bank of America Corp (NYSE:BAC) slashed their dividends after the credit bubble burst.
By contrast, many MLP investments managed to maintain their distributions throughout this turbulent period, overcoming frozen capital markets and plummeting oil and gas prices. MLPs that own midstream assets such as pipelines proved the most resilient; these names tend to garner much of their cash flow from fees and are relatively insulated from fluctuations in commodity prices.
At the same time, uncertainty surrounding the EU sovereign-debt crisis and global economic growth should ensure that volatility rules the stock market. With shell-shocked investors seeking reliable income and growing dividends to offset losses incurred by panicked selling and a flat stock market, expect inflows to the MLP sector to continue apace.
Besides investor psychology, demographic trends bode well for our favorite MLPs. The U.S. Census Bureau estimates that the number of elderly Americans will increase by 36 percent in 2020 and 79 percent in 2030. To meet the needs of this wave of retiring baby boomers, financial planners continue to shift their focus from the best strategies for accruing assets to turning accumulated savings into a lifelong income stream. Not surprisingly, the sustainable yields offered by MLPs appeal to older investors.
Retirees will also gravitate toward the tax advantages offered by MLPs. The Tax Reform Act of 1986 sought to encourage investment in energy infrastructure by exempting the MLP structure from corporate taxes. Similar to real estate investment trusts, MLPs are pass-through entities that transfer any profit or losses to individual unitholders who pay taxes at their ordinary income rate.
Because of depreciation allowances, 80 percent to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the Internal Revenue Service. You don't pay taxes immediately on this portion of the distribution. Instead, return of capital serves to reduce your cost basis in the MLP. You're not taxed on the return of capital until you sell the units.
For example, assume you purchased a unit of an MLP for $50 and receive $5 in annual distributions, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50 until you sell the stock. You'd pay normal income tax rates on the remaining 50 cents.
When you finally sell the units or the cost basis drops to zero dollars, a portion of the capital gains are taxed at the special long-term, capital gains rate. The remainder is taxed at your full income tax rate. In most cases, you should hold MLPs for long periods to get the full benefit of distributions. Deferring 80 to 90 percent of your taxes for several years can be of tremendous benefit, especially for older investors.
Older investors can also rest easy when their MLP holdings pass on to their heirs. An investor's cost basis in an MLP resets to the purchase price when the holder passes away. MLPs can be a valuable component of your estate plan, allowing you to pass along an income-paying asset without owing tax on shielded income.
Financial institutions have been quick to capitalize on rising demand for MLPs, rolling out 23 funds that focus on the group in 2010 and 2011 alone. Not only does this trend raise investors' awareness of the benefits of MLPs, but the added liquidity should also boost unit prices within the sector.
That being said, investors will eke out better returns over the long run by purchasing units of individual MLPs. The funds eliminate some of the headaches with figuring out tax liabilities on MLP holdings, but many expose investors to the double taxation that individual holdings avoid. Also, these funds' portfolios often include a number of marginal names in addition to the sector's top performers.
Investors should instead focus on names like Enterprise Products Partners LP (NYSE:EPD) and Linn Energy LLC (LINE).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.