Tax changes and new funds clear a path for these quirky investments.

    When President George Bush signed the corporate tax reform bill during the height of the presidential campaign last fall, an obscure trade group that represents the interests of macadamia orchards, a Midwestern chain of amusements parks and dozens of oil and gas limited partnerships, was ecstatic. 
    Supporters hoped that the legislation would pave the way for a quirky investment vehicle, called the master limited partnership, to eventually become a fixture in millions of investors' accounts. The law allows mutual funds to invest far more easily in MLPs, which its backers hope will bring far greater exposure to what some experts are calling an invaluable addition to a well-diversified portfolio.
    After the initial jubilation, the Coalition of Publicly Traded Partnerships, which is the MLP trade association, is no longer optimistic that mutual funds will be stampeding into MLPs. A slow trot might be more realistic. The latest hang-up for mutual funds are onerous state income tax laws. But despite the latest roadblock, stock analysts, as well as some investment advisors, insist that these partnerships represent a promising investment for conservative clients, who crave income in the 6% to 8% range. "For older investors at or near retirement, MLPs are a great source of income," suggests Michael Cumming, an energy analyst at Morningstar. "The yields they offer should definitely attract interest."
    With or without mutual funds on board, spectacular results are winning over new fans. For the fifth straight year, MLPs have outmuscled the Standard & Poor's 500 Index. In 2004, Wachovia Securities' MLP Composite generated a total return of 24.1%, versus the S&P 500's 10.9%. During the past three years, the composite produced a compound annual total return of 19.4%, which handily pummeled the blue chip's benchmark of 3.6%.
    Analysts, such as Yves Siegel at Wachovia, are predicting another solid year for MLPs with one significant caveat. "A sharp rise in interest rates would likely lead to a sell-off of MLPs," he says. But the analyst noted, "MLPs should be able to weather a gradual rise in interest rates, particularly those that can generate above-average distribution growth."
    A rise in interest rates in 2005, Siegel suggests, could actually be partially mitigated by the spread narrowing between the yields of ten-year Treasuries and MLPs. At the start of this year, the spread was 209 basis points, versus a five-year average of 267 basis points.
    If you know little about MLPs it's no wonder, since the big boys haven't detected them on their radar. Because of the way MLPs are structured, tax-exempt investors, such as pension funds, can't nibble at these partnerships or they would be hit with the unrelated business income tax (UBIT). Mutual funds also have historically kept their distance, to protect their special tax status as regulated investment companies. Before the American Jobs Creation Act of 2004 was passed, a fund was prevented from earning more than 10% of its income from MLPs without forfeiting its tax status. A section of the act added income from MLPs to the list of acceptable sources of income. A fund can now have up to 25% of its assets invested in PTPs though it can't own more than 10% of any one partnership. With hurdles traditionally blocking institutional players, it's primarily been mom-and-pop investors who have sunk money into these partnerships.
    Just like stocks, MLPs are traded publicly, but investors buy "units" that make them limited partners. The limited partners receive dividends that are called cash distributions. Each MLP is operated by a general partner, who generally has a 2% ownership stake in the partnership and is eligible to receive incentive distributions. When evaluating an MLP, it's smart to examine a partnership's distributions agreements. Incentive distributions are typically based on achieving predetermined pay out levels. Often general partners can earn between 15% and 50% of excess cash flow paid out above the target threshold.
    "The key valuation driver is distribution growth potential," suggests Ronald F. Londe, an analyst at A.G. Edwards. "In our opinion, top-tier growth MLPs exhibit balanced, sustainable growth in distributable cash flow, which should ultimately lead to above-average distribution growth and capital appreciation."
    Many MLPs have been spun off from major corporations in an effort to reduce debt or refocus on faster growth opportunities. Plenty of these jettisoned business units end up showing strong earnings, in part because their management's compensation is linked to the growth of distributions.         Firms also switch to the partnership arrangement to avoid the double taxation that corporations endure. There is no partnership equivalent of the corporate income tax, but in return MLPs must annually distribute nearly all their cash to their partners.
    Within the universe of roughly four dozen MLPs, you'll find most congregating within the energy sector. There are 31 oil and gas product MLPs, three devoted to coal and two that focus on other minerals and timber. Many of the partnerships transport, process and store natural gas, crude oil and refined petroleum products, but they have little exposure to commodity price risk. Most of the remaining MLPs are concentrated in mortgage securities, income properties and homebuilders. And there are a handful of odd ducks, such as Alliance Capital Management Holding L.P., the investment management firm, as well as macadamia orchards in Hawaii and the amusement park chain.
    So why should investment advisors care about these partnerships? Beyond the income bonanza they provide, MLPs can be a dream come true for asset allocators since they provide a low correlation to other equities. Their correlation to the Standard & Poor's 500 Index is in the 25% to 30% range. Both are reasons that attracted Jerry B. Wade, a fee-only investment advisor at Wade Financial Group Inc., in Minneapolis, to invest in MLPs, which he considers to be a subasset class for his clients' commodity exposure. He already invests in PIMCO Commodity Real Return Strategy and sector iShares, but he added MLPs last year after tracking for 18 months a portfolio of MLPs that he assembled on paper.
    Another attractive advantage is the significant tax break that MLPs offer investors. A large chunk of an investor's distribution is shielded from ordinary income taxes. Why? The IRS treats the entire distribution as a return of capital. What investors pay tax on is their share of partnership income. Typically, after subtracting for such things as their share of depreciation, investors often find that just 10% to 20% their distributions are taxable. When investors sell their units, the tax-deferred portion of the distributions are taxed as ordinary income.
    Despite the attractions, it's been the rare advisor who has embraced this odd investment. And it's no wonder. Until recently, trailblazers had to pick their own MLPs, which required time and a level of expertise that some advisors didn't feel they had. Investing in individual MLPs also generate K-1s for clients, which is never welcome. What's more, some larger unitholders may have to file tax returns in certain states where a partnership conducts business. It's this state income tax hurdle that is discouraging mutual funds from embracing MLPs.
    But for some advisors, the irritating tax requirements melted away in 2004 when four closed-end funds, all devoted to MLPs, hit the markets. If you invest through a closed-end fund, you avoid K-1s and state tax filings. The closed-end funds deal with that headache. The new investment choices are Kayne Anderson MLP Investment Company, Tortoise Energy Infrastructure Corp., Energy Income and Growth Fund and Fiduciary/Claymore MLP Opportunity Fund. For advisors, who prefer making their own picks, Wachovia recommends these partnerships:  Energy Transfer Partners L.P. (ETP), Kinder Morgan Energy Partners L.P. (KMP), Magellan Midstream Partners L.P. (MMP), Inergy L.P. (NRGY) and Markwest Energy Partners L.P. (MWE). Siegel predicts that the MLPs, which experience above-average distribution growth, should generate total returns in the mid- to high single digits in 2005.
    It was the availability of these closed-end funds that encouraged Wade to make the plunge. He acknowledged, however, that one of his colleagues was leery of investing in any of the closed-end funds because they were all trading at premiums, which recently ranged from 1% to 3%. "We were willing to pay a premium for this asset category, but normally that's a no-no for our firm. We like to buy discounts." When adding to the firm's position, he plans to buy on dips. If mutual funds do enter the market, Wade added, the firm will switch to the open-ended funds.
    The closed-end cavalry hasn't chased away all the irritations for advisors. Here's perhaps the biggest remaining headache:  Owning individual MLPs in an individual retirement account is a faux pas, since it can trigger the dreaded UBIT. The Internal Revenue Service will consider any earnings over $1,000 as unrelated business taxable income. Mary Lyman, who is executive director of the Coalition of Publicly Traded Partnerships, says there is a strong likelihood that the trade group will urge Congress this year to drop the IRA prohibition. "We know there are individuals buying (MLPs) and putting them in an IRA, who are later horrified to discover they have to pay taxes."
    MLPs can cause a few other headaches. Generally, distributions aren't guaranteed. While most MLPs pay out as much as possible, they have rather broad discretion when determining distribution pay outs. In addition MLPs, which are generally prized for their price stability, can experience meltdowns. For instance, Star Gas Partners L.P. (SGU) plunged 70% in 2004 after it violated certain financial debt covenants in the fourth quarter due to its inability to pass through higher heating oil prices and customer attrition. Investors fled in droves after the partnership suspended payments of distributions.
    But supporters suggest the allure of these partnerships will attract more investors. Londe of A.G. Edwards predicts that mutual funds, and especially equity income funds, will grow increasingly interested in MLPs. "Currently, there are very few ways of investing for income within the energy sector. This MLPs would be a natural solution to this dilemma."
    Cumming of Morningstar suggests that the attractions could be strong enough for funds to tolerate the state-tax snafus. "If they can make enough money, it could be worth the hassle even if the state taxes are somewhat burdensome."
Lynn O'Shaughnessy is a syndicated financial columnist based in San Diego and the author of three books, including The Retirement Bible.