Investors who are disgruntled with erratic returns from stocks and are searching for yield are increasingly moving into Master Limited Partnerships (MLPs).
Once considered esoteric and limited to sophisticated investors, MLPs are publicly-traded on the NYSE and NASDAQ. They offer yields in the form of quarterly distributions, which are similar to stock dividends, as well as tax deferrals on a majority of the income they generate. As a result, these investments are appealing to investors in higher tax brackets. The asset class may be timely given the potential expiration or limited extension of the Bush tax cuts.
MLPs generally represent investment in energy, natural resources, petroleum, natural gas extraction and transportation, especially pipelines to ships conveying commodities. According to Michael Blum, a managing director at Wells Fargo Securities, a unit of Wells Fargo, about 90% of new equity in the energy-related MLPs last year came from retail investors.
MLPs are concentrated in the energy sector due to the prevailing tax code. More than 75% of U.S. MLPs now trading are energy-related because the tax code limits the type of income they can earn mainly to natural resources businesses, according to the National Association of Publicly Traded Partnerships, a Washington trade group.
Typically 75% to 80% of the cash distributions are tax-deferred until units of the MLP are sold. This is what makes them attractive to high-income investors concerned about taxes, who want to take advantage of investing directly in publicly-traded MLP units. An MLP combines the tax benefits of a limited partnership (i.e. avoiding taxes at the corporate level) with the liquidity of publicly-traded securities.
MLPs have become very popular because the tax obligations on their distributions are effectively interest-free loans from the federal government until the MLPs are sold.
Another benefit is that MLPs generally offer stable yield, as they are required to pay minimum quarterly distributions to the limited partners by contract.
Study MLP Vehicles Carefully
Investors should be concerned about the vehicles they use to invest in MLPs. Dan Plettner, a long-term, risk-averse MLP investor who licenses his portfolio data to Covestor, treats the MLP allocation of his investment portfolio very differently from other asset classes.
Plettner has researched and evaluated the conflicts of interest in unique underfollowed securities such as closed-end funds. Based on his research, Plettner avoids ETFs, exchange-traded notes (ETNs), and closed-end funds (CEFs) for the MLP asset class and owns a diversified group of 16 MLPs directly.
Plettner says the C-Corporation structure of MLP focused ETFs, CEFs, and mutual funds expose an investment to corporate tax liability, which significantly detracts from NAV performance. He says that unless there is significant managerial performance or outperformance, their NAVs are likely to capture less than 70% of long-term upside moves.
In contrast, the ETN vehicles for asset class exposure also have significant problems. ETNs are credit products and the asset class inefficiency here is worse than just credit risk. Although the ETNs capture upside better than the ETF, CEFs, or mutual funds, their distributions paid to the shareholder don’t get the MLP distribution tax treatment. Plettner said “this is akin to paying Federal Income Tax on a Municipal Bond’s Payments.”
Tax Advantages of MLPs
The advantage of the MLP asset class comes from its favorable tax treatment. As a result, MLP holdings should be held in investor’s taxable accounts. Investors who want to include MLPs in their portfolios might select their own, or they can follow Plettner’s Direct Ownership MLP holdings on Covestor to retain all the MLP asset class’ advantages. Plettner’s Covestor portfolio allows shareholders to directly own a diversified portfolio of MLPs at 0.75%, a cost that he said is competitive with any of the single security products.
The tax efficiency of MLP investing is maximized when the investor uses their taxable accounts to holds MLPs for the long term. “An efficient MLP investor typically wants their cost basis to go to zero and make the most of the interest free loan Uncle Sam has provided them to encourage their domestic infrastructure investment” says Plettner.
Plettner said he uses fundamental research to select well-managed MLPs which have corporate governance and goals which are aligned with investors’ interests, “As a rule of thumb, the higher a MLPs current distributions, the greater the long-term risk. To peak out Incentive Distribution Rights, not to the ordinary investor, but the general partner, boards can authorize paying out unsustainable cash flow and in the process, they can run the business into the ground,” according to Plettner.
To prevent this, Plettner said it’s important for investors to investigate the MLP’s “naturally sustainable cash flow distributions,” as well as the absence of governance conflicts of interest to pay risky distributions. “This is why I seek to buy MLPs that I can feel comfortable owning for 50 years or more. Ideally, I want to live a full life and then die with them,” he said.
Five MLP Recommendations
Here are five specific MLP holdings that have been screened by Plettner for yield, risk, governance conflicts of interest, tax efficiency and for not paying incentive distributions to the general partner. Plettner said the following investments were made for the long term and because the MLPs are exposed to lesser conflict-of-interest risks between the general partner and investors.
|Magellan Midstream (NYSE: MMP)||5.32%||Oil Well Services & Equipment|
|Markwest Energy (NYSE: MWE)||6.02%||Natural Gas Utilities|
|Linn Energy (NYSE: LINE)||7.36%||Oil & Gas Operations|
|Legacy Reserves (NYSE: LGCY)||7.80%||Oil & Gas Integrated|
|Vanguard Natural Resources (NYSE: VNR)||8.48%||Oil & Gas Operations|
As of this writing, Chuck Epstein did not own a position in any of the individual stocks or ETFs named here.