Caveat Emptor for MLP ETFs

05/17/2012 8:15 am EST

Focus: ETFs

Peter Staas

Managing Editor, Capitalist Times and Energy & Income Advisor

Master limited partnership exchange traded funds aren't rolling into the marketplace quickly yet, but even with a limited number available, investors need to be cautious, writes Peter Staas of Personal Finance.

There’s no denying the appeal of master limited partnerships to income-seeking investors, particularly in this low-yield environment. Relative to the yields offered by traditional fixed-income investments, the Alerian MLP Index’s 5.78% yield appears downright magnanimous.

At the same time, the yield offered by the MLP benchmark has tumbled from its 12-month high of 7.39% (hit on August 8, 2011) after the index appreciated by 24%. Investors who were along for the ride will be pleased by these gains, but those looking to add money to the sector may be disappointed by prevailing yields.

Yorkville High Income MLP (YMLP), only the second exchange traded fund to focus on energy-related master limited partnerships, launched in mid-March 2012.

Income-seeking investors may be enticed by the average 8.5% distribution yield of the ETF’s underlying holdings. However, higher yields can often accompany excessive risk.

Although Growth Portfolio stalwart Linn Energy LLC (LINE) is one of the ETF’s top ten holdings, the fund also includes outsized exposure to some of the riskiest names in the MLP universe, many of which we rate a “Sell” in Personal Finance’s sister publication, MLP Profits.

The initial public offering of Yorkville High Income MLP marks a trend that’s gathered steam: Investors can now choose from 41 fund products—20 closed-end funds, 11 mutual funds, and ten exchange traded products—that offer one-stop exposure to MLPs, 29 of which have been rolled out in the past three years.

Investors’ appetite for these products reflects the intertwined factors of investor psychology and demographics.

Many income-seeking investors remain scarred by the stock market implosion that accompanied the global credit crunch and Great Recession, a period that reminded investors of the risk involved in investing in higher-yielding fare. Few will forget the panic that ensued when corporate titans such as General Electric (GE) were forced to slash their dividends after the credit bubble burst.

By contrast, many energy-related MLPs 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.

At the same time, uncertainty surrounding the EU sovereign-debt crisis and global economic growth should ensure that volatility once again rules the stock market through at least 2012. With shell-shocked investors seeking reliable income 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 also bode well for energy-related MLPs. The US Census Bureau estimates that the number of elderly Americans will increase by 36% in 2020 and 79% in 2030. The sustainable, tax-advantaged yields offered by MLPs hold a great deal of appeal for investors seeking to convert accumulated savings into a lifelong income stream.

Investors will eke out better returns over the long run by purchasing units of individual MLPs. The funds pushed by the various investment houses mitigate the headaches of calculating tax liabilities on individual MLPs, but many of these funds expose investors to the double taxation that individual holdings avoid. Also, these funds’ portfolios often include marginal names in addition to the sector’s top performers.

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