As an investment category, master limited partnerships (MLPs) have long been popular with investors who want to generate tax-advantaged income from their investments. These entities are generally built around natural resources (especially the transport of oil and/or gas), and in exchange for passing along a very high percentage of earnings to shareholders, they are given preferential tax treatment.
Unfortunately, ownership of MLPs can significantly complicate an investor’s tax returns, and there are always company-specific risks to consider. ETFs offer a real advantage because they not only diversify the risk, they also provide a simple Form 1099 to investors instead of a K-1. On the downside, MLP ETFs/ETNs are still relative newcomers to the market, and there aren’t a lot of large or liquid options.
Given that so many MLPs are built around midstream, storage or energy transportation businesses, it’s not too surprising that the energy markets have a meaningful influence on these units. While some MLPs operate in regulated environments where prices are carefully controlled, others do not – in either case, changes in volume (often tied to the economic conditions of the region or country) can significantly impact anticipated distributions and unit prices.
MLPs also move on capital expansion plans and interest rates. Capital expansion generally means a larger asset base from which to generate future distributions, but often at the cost of higher interest payments and/or share dilution, as well as increased risk. Given that MLPs make extensive use of debt financing and are often seen as alternatives to bond investments, these units are also quite sensitive to interest rate moves.
Where They Fit
MLPs, and by extension MLP ETFs and ETNs, are typically seen as more conservative, income-oriented investment options. For example, the largest ETN by asset value, the JPMorgan Alerian MLP Index ETN (AMJ), presently offers a 5% yield––more than double the yield of the S&P 500.
Although undervalued MLPs can offer attractive capital gains, by and large MLP ETFs/ETNs are best suited for those more interested in steady income accumulation as opposed to capital gains. Although MLPs don’t tend to be volatile on a day-to-day basis, they can move quite dramatically in response to new interest rate expectations or proposed changes to tax laws.
Factors To Consider
There aren’t many MLP ETFs out there, but they are a pretty diverse bunch. AMJ, for example, is designed to match the Alerian MLP Index and those returns are backed by the credit of JPMorgan. In exchange for that credit risk, there is better tax efficiency and no tracking error.
When choosing between these funds, consider whether you want an ETN (again, more credit risk, but no tracking error and better tax efficiency) or an ETF. Beyond that, the choices really revolve around whether you want a leveraged vehicle (increasing the risk, but also the return potential) or a fund that focuses more on higher-yielding, riskier MLPs.