Download The Darker Side of Higher Yields - Twenty

WEEKEND INVESTOR | AUGUST 9, 2013, 6:52 P.M. ET
The Darker Side of Higher Yields
By LAURA SAUNDERS
Master limited partnerships, the publicly traded energy firms offering the steady high income
many people crave, have been hotter than a wellhead fire.
Investors should proceed carefully, however, or they
might get scorched. Lured by generous quarterly cash
payouts, investors poured nearly $8 billion into mutual
funds and exchange-traded products specializing in
MLPs in the first half of 2013, according
toMorningstar, MORN +0.19% the investment-research
firm. More than one-quarter of the roughly $26 billion in
the total assets at these funds has arrived since Dec.
31.
MLPs' returns have been strong. Over the decade
ended July 31, MLPs generated an average total return,
or income plus price changes, of 16% annually; U.S.
stocks overall, as measured by the S&P 500, returned
an annual average of 7.6%.
The Alerian MLP AMLP +0.20% index, a widely followed
benchmark, has a yield (income divided by price) of 5.7%—more than double the interest income
on 10-year U.S. Treasury debt and nearly triple the dividend on the S&P 500.
Many analysts expect those yields, already extraordinary in a world of rock-bottom interest rates,
to rise steadily over time as the energy boom picks up speed.
MLPs also provide a regular stream of cash payments that have kept up well with inflation and
often are largely exempt from current income tax. Historically, MLPs haven't moved in sync with
the S&P 500—enabling investors in these firms to reduce the riskiness of an all-stock portfolio.
Yet even bullish analysts are worrying that risk has begun rising among MLPs as money pours in,
driving up valuations and pushing down the quality of some offerings. An earlier generation of
MLP investors lost most of their money in the mid- to late-1980s when oil prices collapsed, recalls
James Murchie, founder and portfolio manager at Energy Income Partners in Westport, Conn.,
which manages $4 billion.
"If you wanted to launch an MLP in the 1990s, you had to be Albert Schweitzer wrapped up
inside Albert Einstein," he says. "But now, so much money is flowing in that mistakes are easier
for investors to make."
Expectations have climbed so high that small missteps can send an MLP tumbling. This past
Wednesday, Southcross Energy Partners, SXE -0.56% a Dallas-based natural-gas MLP, plunged
5% when it reported lower-than-expected cash flow.
Mutual funds or exchange-traded funds holding a basket of MLPs also can cost you dearly; the
average MLP mutual fund charges 1.44% in annual expenses, or $144 per $10,000 invested,
while the average ETF charges 0.82%, according to Morningstar. Meanwhile, investors can own
a conventional ETF holding energy stocks for as little as 0.14% annually.
MLPs' yield is vulnerable to rising interest rates, too. That is especially true at smaller firms that
fund operations with debt and thus would be hurt as rising rates raised their borrowing costs,
says Ethan Bellamy, an analyst specializing in MLPs at Robert W. Baird & Co., a Milwaukeebased brokerage and investment bank.
Above all, MLPs and funds specializing in them are riddled with tax complexities that can weigh
on returns, especially for people with less than about $250,000 to invest in the sector.
The tax hazards of buying individual MLPs include large tax-preparation costs; the inability to
deduct current losses against other income; and the risk of generating taxable income even
within a tax-free individual retirement account or Roth IRA.
These issues are the drawbacks of MLPs' tax-favored status. Although they are publicly traded,
MLPs are very different from the corporations that dominate the stock market. As partnerships,
they "pass through" net income directly to their "limited partners," or investors, who owe tax at the
individual level. Thus there isn't a corporate-level tax for individual MLPs.
Because the cash flow distributed to investors by MLPs often is largely sheltered by depreciation
and other tax breaks they are allowed by law, investors often can defer paying income tax on the
payouts almost until the position is sold. "The longer the holding period, the greater the tax
benefits," says Simon Lack, managing partner of SL Advisors, an asset manager in Westfield,
N.J.
But MLP payouts aren't tax-free—just tax-deferred. To keep track of what is deferred, partnership
investors receive annual K-1 reports at tax time instead of fairly simple 1099 forms from a broker.
These reports often require multiple state tax filings and expensive tax-preparation help.
Selling a holding sometimes triggers large unexpected payments to Uncle Sam involving arcane
items such as depreciation recapture.
"We've had clients sell MLPs after their adviser told them they had no significant gain or loss,"
says Jim Oliver, a certified public accountant in San Antonio. "But the actual result was a large
ordinary gain and a large capital loss"—a bad tax outcome.
In an effort to circumvent some of these issues and satisfy demand from smaller investors, many
firms are offering MLP funds—but these present other hazards, including high fees, credit risk or
an extra layer of tax.
"Some MLP funds severely compromise the tax efficiency they tout," says Robert Gordon, head
of Twenty-First Securities in New York, a tax-strategy firm.
For example, many funds devoted to MLPs are unlike regular mutual funds and ETFs that pass
through income. Because of their special holdings, they owe taxes as a C-corporation would—so
they owe taxes of 35%, unlike individual MLPs. This means that "$1 of MLP income turns into 65
cents before investors receive it," he says.
Such taxes often are deferred until later, but they are subtracted from the fund's net asset value
so that all investors in the fund will bear them equally.
As a result, the reported expense ratio of such MLP funds can vary widely as their returns go up
and down. In a boom year, the funds will accrue a whopping deferred tax liability. Recently, for
example, the charge—which is passed along to investors in addition to the fund's expenses—has
been equal to 3.07% of assets at the Global X MLP MLPA +0.44% ETF and 4% at the Alerian
MLP ETF AMLP +0.20% .
This added cost also means that the funds' returns can vary widely from those of their
benchmarks, with Alerian underperforming by roughly nine percentage points so far this year and
Global X trailing by approximately 10 points. Conversely, in a falling market the deferred taxes
will be added back to returns, helping these funds beat their indexes.
"You're going to see these things perform so differently from their indexes that investors will
mostly be disappointed," says Dave Nadig, president of ETF analytics at IndexUniverse, a fundresearch firm in San Francisco.
Jeremy Held, director of research at ALPS Advisors, which distributes the Alerian MLP ETF, says
that such ETFs open the market to investors who otherwise couldn't afford to buy a sufficient
number of MLPs to build a safe portfolio.
"We're very explicit in trying to explain [a tax liability] that is complex," says Bruno del Ama, chief
executive of Global X.
The upshot? "There's no perfect vehicle for owning MLPs," says Nathan Kubik, an adviser at
Carnick & Kubik in Greenwood Village, Colo. Instead, investors should weigh the pros of cons of
each option. (For a list of questions to ask before buying, see the box on this page.)
Here is a guide to five ways to invest in MLPs.
Individual MLP Units
There are more than 100 energy-related MLPs with a combined stock-market value of more than
$400 billion, according to the National Association of Publicly Traded Partnerships.
These can be a highly tax-efficient structure for investors with taxable accounts, but they often
require complex record keeping.
Mr. Oliver, the San Antonio accountant, estimates that each K-1 annual report "could easily" add
$150 to $200 in tax-preparation costs per year, or double that amount if the holding is sold,
because of possible multistate filings.
Examples of individual MLPs include such well-regarded firms as Enterprise Products
Partners, EPD +0.19% Magellan Midstream Partners MMP -0.01% and Plains All American
Pipeline PAA +0.07% . Unlike with other investments, putting individual MLPs in a tax-favored
retirement plan such as an IRA or Roth IRA won't resolve tax issues. That is because MLPs
typically have more than $1,000 of unrelated business taxable income, which generates taxable
income within an IRA and requires complex record keeping.
MLP I-Units
These MLP investments can offer tax efficiency to individual holders willing to forgo what some
consider the chief attraction of MLPs, which is cash payouts. Two firms offer them: Kinder
Morgan KMI -0.93% Management and Enbridge ENB +0.09% Energy Management, allied with
MLPs Kinder Morgan Energy Partners KMP +0.19% and Enbridge Energy Partners, EEP 0.67% respectively.
Originally designed to attract tax-exempt institutions such as pension funds, these publicly traded
corporations hold MLP units and make distributions to investors in the form of more shares
instead of cash.
According to Mr. Gordon, the tax strategist, the corporation issuing I-units pays little to no U.S.
income tax, and the payouts to investors aren't taxable until shares are sold. Profits on shares
held longer than a year count as long-term capital gains, which are taxed at favorable rates.
The tax reporting for MLP I-units also is relatively simple in that taxpayers get a 1099 form when
they sell shares, instead of a K-1 tax report.
MLP Funds Taxed as C-Corporations
This category includes ETFs, mutual funds and closed-end funds. Such funds offer
diversification, tax-deferred or qualified dividend payouts, and relatively easy record keeping in
the form of annual 1099 forms. If shares are held in a retirement account, there is no issue with
unrelated business taxable income.
As described earlier, however, such funds incur a corporate-level tax of 35% on net income. It is
borne by investors and can greatly increase annual expenses and make costs hard to predict.
In addition to the ETFs mentioned above—Alerian MLP and Global X MLP—options include
ALPS/Alerian MLP Infrastructure Index A, a mutual fund, and First Trust MLP and Energy Income
Fund, a closed-end fund. The Alerian ETF charges annual management fees plus deferred taxes
that total 4.85%, or $485 on a $10,000 investment; total costs for the Global X ETF are 3.52%,
while ALPS/Alerian MLP Infrastructure charges up to 1.85% and the First Trust closed-end fund
charges expenses of 1.37% and has a deferred tax expense of 15.7%.
MLP Funds That Aren't C-Corporations
These MLP funds are like conventional mutual funds, offering diversification and generating 1099
tax reporting forms instead of K-1 reports. But they also are tax-efficient because they don't owe
corporate-level taxes, and they pay out income and gains to investors as mutual funds do.
To maintain this tax-favored status, however, no more than 25% of such funds' assets can
consist of direct MLP holdings. Some funds in this category have dealt with this constraint by
making further MLP investments through subsidiaries.
In early August the Internal Revenue Service challenged such indirect holdings. This past week
the sponsor of one closed-end fund in this category, Salient MLP & Energy Infrastructure
Fund, SMF -0.30% said that if the IRS's proposal is adopted, it will comply by changing its
holdings. Other funds in this category include Tortoise MLP & Pipeline Investor and Famco MLP
& Energy Income.
The Salient fund charges annual fees of 2.25%, while the Tortoise and Famco funds cost 1.35%
and 1.50%, respectively.
MLP Exchange-Traded Notes
These products, which include JPMorgan Alerian MLP Index and Credit Suisse MLP Index, aren't
MLP funds at all. Instead, they are unsecured debt instruments designed to replicate the return of
an MLP index.
As such, they are a simple way to get MLP exposure, because they issue 1099 forms and pose
no problems in retirement accounts. The caveat: They aren't tax-efficient. The payouts are all
ordinary income, taxed at federal rates of 43.4% for top-bracket investors, plus state taxes.
The J.P. Morgan and Credit Suisse notes charge annual fees of approximately 0.85%.
In addition, ETNs can be expensive to buy or sell and differ from other MLP investments because
they expose holders to the credit risk of the issuer. Although this may seem a remote concern, it
is a real one—as holders of Lehman Brothers' structured notes discovered.
According to Craig McCann, an economist with SLCG in Fairfax, Va., a financial consulting firm,
in the aftermath of Lehman's demise in 2008, $18.6 billion worth of such notes were worth
pennies on the dollar.
Write to Laura Saunders at [email protected] and Jason Zweig
[email protected]
A version of this article appeared August 10, 2013, on page B7 in the U.S. edition of The Wall Street
Journal, with the headline: The Dark Side of Higher Yields.
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