One way around this potential tax headache is to invest in master limited partnership exchange-traded notes, exchange-traded funds and closed-end funds, structured as C corporations. With these investments, clients get a 1099 and can invest in an IRA without those complex tax consequences.
Financial research shows that master limited partnerships can be a good diversifier. They have low correlations to stocks, bonds and REITs. For example, over the past 15 years ended in February, according to Morningstar Inc., Chicago, the Alerian MLP index had a monthly 0.36 correlation to stocks, 0.39 to utility stocks and REITs and just a 0.05 correlation to bonds.
In addition, the Alerian MLP Index has outperformed REITs, utility stocks and the S&P 500 over the past decade.
Morningstar's back-tested research also shows that a portfolio with a 10% allocation to master limited partnerships, and the rest split among large- and small-cap U.S. stocks, international and emerging market stocks, as well as bonds and commodities, grew at an annual rate of 8.6% over that 15-year period. By contrast, the portfolio without the master limited partnership allocation grew at a 7.6% annual rate. The portfolio with the master limited partnership also registered a higher risk-adjusted rate of return as measured by the Sharpe ratio.
A portfolio with a 10% allocation to master limited partnerships also outperformed the risk-adjusted return of a portfolio with, instead, a 10% allocation to REITs.
Past performance, however, is no indication of future results. This year, to date, the Alerian MLP index has underperformed REITs, bonds and utility stocks because of the collapse of natural gas prices and drop in cost of oil.
"Master limited partnerships are well worth it," says Dennis Melchior, financial advisor with UBS Price Wealth Management in Palm Beach, Fla. "They have low correlations to other assets, and partnership prices are depressed. Master limited partnerships can provide good income and good exposure to energy resources."
Like REITs, master limited partnerships pay out most of their earnings to investors. As a result, Melchior says he can increase client cash flow by adding both to a portfolio comprising a bond ladder and dividend-paying stocks.
Master limited partnerships he recommends for non-IRA accounts include Energy Transfer Partners, a natural gas company that extracts, distributes and stores gas; Enterprise Product Partners, an oil and gas company that extracts gas and crude oil (it also refines and produces petrochemicals); and MarkWest Energy Partners, which, together with its subsidiaries, gathers, processes and transports natural gas.
Two master limited partnership exchange-traded funds he recommends for IRAs include the exchange-traded Steel Path MLP Alpha and Cushing MLP Premier. Investors report the income on the 1099 tax form.