Master Limited Partnership (MLP)
Features, Advantages and Limitations
If you're investing for income, Master Limited Partnerships, or MLPs, can be a potential source of attractive yields.
What is an MLP?
An MLP trades like a common stock, but – since it is a partnership by law – it carries the tax benefits of a partnership (i.e., no federal or state income taxes on the corporate level). Investors buy “units” of partnerships rather than shares, and they are referred to as “unitholders” rather than “shareholders.”
Because MLPs do not have to pay corporate taxes, they have more cash available to fund their distributions. To organize as an MLP, a firm must earn 90% of its income from activities related to natural resources, commodities or real estate. Consequently, a number of MLPs are the slow-growth businesses – such as pipelines and storage terminals – that energy companies have spun out over the years. The majority of MLPs’ operations are based in North America.
Since the underlying businesses are slow-growth, investors shouldn’t expect substantial long-term capital appreciation. However, slow growth also equates to stability, which means that MLPs – while traded on the stock market – tend to be less volatile than typical natural resources stocks. One reason for this is that they generally aren’t dependent on commodity prices to generate earnings. Also, investors can typically earn attractive yields that are above those available in many areas of the equity or bond markets.
How to Invest in MLPs
Investors can buy individual MLPs using a brokerage account, or they can opt for closed-end funds or exchange-traded notes (ETNs). MLPs are also available via the Alerian MLP exchange-traded fund, or ETF (ticker: AMLP), which offers diversified access to this market segment via a single investment.
Some of the largest individual MLPs are Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), Plains All American Pipeline (PAA), and Energy Transfer Partners (ETP).
Be sure to consult your tax advisor before investing in MLPs or any instrument that invests in MLPs. Owners of individual MLPs must file a special tax form known as a K-1 every year, although this isn’t necessary with an exchange-traded fund, such as the Alerian MLP.
Returns of MLPs
As of March 31, 2014, the Alerian MLP Index (AMZX) had produced a ten-year average annual total return of 14.9%. Real-estate investment trusts, or REITs, returned 8.2% annually in the same time period, while utility stocks’ total return was 9.7%. Both REITs and utilities are popular options for income-oriented investors. The S&P 500 Index, a broad measure of performance for the U.S. stock market, averaged an annual gain of 7.4% in the same period. Keep in mind, these returns are historical and are not indicative of future results.
As of that same date, the yield of each asset class was as follows: MLPs, 5.7%; REITs, 4.0%; utilities, 4.1%; S&P 500, 2.2%.
Risks of MLPs
MLPs tend to perform better (in terms of their price action) when interest rates are low or falling. When rates are elevated or rising, MLPs generally deliver lower returns. One reason for this is that when rates are low, investors move out of safer assets to seek income in other areas of the market, such as MLPs Conversely, when rates are high, investors will gravitate back to U.S. Treasuries or other lower-risk fixed income investments.
MLPs also face regulatory risk in the sense that their structure is determined by the tax code. If the tax code were to change in an adverse manner, stripping MLPs of some of their tax benefits, their prices would react negatively. The likelihood of this is low, but it is a consideration.
MLPs in Portfolio Construction
Historically, MLPs have a low historical correlation with other areas of the market – meaning that they tend to fluctuate in a relatively independent fashion rather than being tied to the performance of the broader market. As a result, holding MLPs increases portfolio diversification in uncorrelated assets -- that is, assets that do not necessarily move in tandem with others.