Promise and peril in master limited partnerships

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By Jeffrey R. Kosnett
Sunday, October 17, 2010

Master limited partnerships - relatively obscure, high-yielding investments that flourished over the past decade while the rest of the stock market stagnated - are attracting a lot of attention. Maybe too much, in the view of some of their fans.

Reports of double-digit total returns and 6 percent-plus current yields are all over the investing blogs, and a flurry of new MLPs are on the way. The first mutual funds - and an exchange-traded fund - focusing on MLPs launched this year, and an increasing number of institutional investors are getting into the game. Longtime MLP watchers wonder whether the category is destined to crumble beneath a landslide of greed.

Their concerns are valid. The situation reminds me of how real estate investment trusts and cargo-shipping stocks, two other high-yielding niche categories, busted after their booms attracted a rush of capital. And MLPs have indeed boomed. Over the past 10 years, through Sept. 3, the Alerian MLP index, which tracks 50 energy MLPs (a few MLPs are not related to energy), returned a stunning 18.5 percent annualized. Over the same period, Standard & Poor's 500-stock index lost 1.3 percent percent a year. The Alerian index currently yields 6.7 percent.

MLPs are publicly traded limited partnerships. Like other limited partnerships, MLPs pay no taxes on their earnings. However, investors (called unit holders) must pay taxes on the distributions they receive and often have to contend with complex K-1 forms. Most MLPs collect fees for the transport or storage of various forms of energy.

Energy companies are gaga over the potential gas output from shale formations in Texas, Louisiana, the Rockies and the Appalachians. If producers succeed in extracting gas from shale, they will need pipelines, processing plants and storage facilities. That will mean the creation of new MLPs. Kenny Feng, head of Alerian, a research firm that specializes in MLPs, figures that the sector can efficiently absorb an additional $150 billion worth of investment. That's nearly three-fourths of the current market value of all energy MLPs. However, our energy use won't increase by as much anytime soon, so a glut of new MLPs may weigh on the sector.

And the increased attention makes some advisers nervous. "Once you get noticed in the press, too much money floods in," says Mickey Cargile of WNB Private Client Services in Midland, Tex. He recommends that MLPs be no more than 20 percent of clients' income-generating investments, with no more than 5 percent in a single issue.

The new MLP funds appear unappealing. Alerian MLP ETF (symbol AMLP) has a serious tax flaw: Because investment companies may not hold more than 25 percent of their assets in partnerships, the ETF is not legally a mutual fund but rather a corporation. That makes the MLPs earnings taxable at a corporate rate of up to 35 percent. That will be a serious drag on performance. Three MLP mutual funds started in March by SteelPath, an Alerian spinoff, have the same tax problem. Plus, they levy sales charges and charge high ongoing fees.

The funds' main selling point is that they relieve you of the burden of dealing with pesky K-1 forms when you do your taxes. You also avoid the mess that arises if you earn more than $1,000 of unrelated business taxable income inside an IRA. You're better off buying MLPs directly and using an accountant if necessary. My top picks for conservative investors are Magellan Midstream Partners (MMP), which, at a Sept. 10 closing price of $50, yielded 5.9 percent, and Plains All-American Pipeline (PAA), which at $62 yielded 6.1 percent. A sleeper is Enbridge Energy Partners (EEP), a leading carrier of crude oil from western Canada to the United States. It has less debt than most MLPs and so far has raised dividends twice in 2010. At $54, it yields 7.6 percent.

Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.

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