Not All MLPs Are Created Equal

04/05/2013 7:45 am EST

Focus: ETFs

Investors who don’t look beyond the lofty yields of MLPs may have a rude awakening, says Samuel Lee of Morningstar ETFInvestor.

Investors love master limited partnerships because they offer juicy yields. If you feel that love, whatever you do, think hard before you invest in this fund. No matter how attractive MLPs themselves may be, the unfavorable tax regime this fund labors under is a major drag on performance.

From its inception to the end of January this year, ALPS Alerian MLP ETF (AMLP) has lagged its benchmark by nearly 8% annualized, according to the fund’s Web site.

With that kind of underperformance, I’m not sure why investors have so eagerly piled into this fund. As analyst Abby Woodham notes, MLPs may be the rare case where it’s better to own an exchange traded note than an exchange traded fund.

AMLP’s gaping underperformance relative to its benchmark owes much to its tax treatment as a corporation, which is generally less favorable than the tax regime most mutual funds fall under. Unfortunately for AMLP’s investors, the taxes come right out of the fund’s net asset value, so although AMLP’s prospectus expense ratio is 0.85%, investors are really paying closer to 5%, all told.

The modest upside to this rather heinous tax cost is the shareholder in AMLP doesn’t have to deal with the hassle of filing a K-1 form with the IRS every year. Is it worth it? Doubtful.

So, why would an investor own MLPs other than for their generous yields? While MLPs are heavily involved in commodity markets, their financial performances are less tied to commodity prices and more to the total volume of gas or oil they process and transport. The rates they charge are often regulated, providing regular, predictable income streams.

On top of that, it’s usually not economical to have several pipelines or facilities serving the same areas, so the infrastructures run by MLPs are often local monopolies.

The favorable economics and high yields have attracted a lot of investor dollars, and our analysts think MLPs are trading near fair value. Overall, you shouldn’t expect standout returns from MLPs. After this ETF’s taxes are taken into account, you may be in for disappointing returns.

If you really don’t want the hassle of owning MLPs directly and dealing with the K-1 forms, consider an exchange traded note like JPMorgan Alerian MLP Index (AMJ), which not only rids you of messy tax complications, but is guaranteed to track its index minus its annual 0.85% charge.

The downside is you bear the risk that the issuing bank, JPMorgan Chase (JPM), goes bust and leaves you standing in line after a bunch of other creditors in order to (maybe) recover part of your investment.

And AMJ has problems of its own. JPMorgan stopped creating new shares in June 2012, so the note can sometimes trade at unusually high premiums. AMJ charges a 0.85% annual fee, but unlike a mutual fund's expense ratio, AMJ’s quirky fee calculation can end up costing investors more or less than 0.85% of assets per year.

And—though unlikely—AMJ’s tax advantages may be moot if Congress passes certain reforms being contemplated right now.

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