The fifteenth-century Dutch philosopher, Desiderius Erasmus, is said to have remarked that “In the land of the blind, the one-eyed man is king.”
The saying could not have been more apt for the yield-starved investment universe of the past decade. At a time when the yields of many income-producing assets languished, master limited partnerships (MLPs) offered some solace, yielding 5-7%. No wonder, MLPs were treated as kings by income-loving investors during the initial part of the decade.
MLPs, however, come in all kinds of flavors. Investors would do well to choose the one that suits their palette. This is important because how MLPs are accessed could have an implication on the risk and return opportunities for investors. What’s more? The type of MLPs you choose could also decide the fees and taxes you pay.
This article will help you differentiate between the various stripes of MLPs and the myriad vehicles through which you can gain exposure to them.
What Are MLPs?
Before taking a plunge into the world of MLPs, consider the following words about them. An MLP is a financial entity that combines the features of a corporation and a partnership. Like the share of a corporation, the ‘unit’ of an MLP is tradable and is accessible by a brokerage account. However, like limited partnerships, MLPs are not incorporated and can pass through incomes and gains directly to shareholders without being taxed at the entity-level. The MLP structure is a favorite among the energy sector, and oil and gas pipelines distributors often operate as MLPs.
This unique structure of MLPs comes with a quirk that is actually loved by income-seeking investors. They must pass on a majority of their cash flow as distributions to unitholders. As a result, they are considered as yield-oriented investments. In addition, MLPs yield additional benefits by enhancing total return and diversification potential. Nonetheless, there are two predominant ways – direct and indirect – to access this asset class.
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Want the Direct Route to MLPs? Take the K-1
With the direct route, MLPs can be purchased just like shares through a brokerage account. Take, for example, the case of Magellan Midstream Partners (MMP ), a partnership that stores and transports petroleum products across the U.S. All you need to access this investment is to buy its units in the NYSE just as you would buy any other stock through a broker.
Investors who buy units of MLPs become partners in the business and not shareholders. While the difference between a unitholder and a shareholder might look subtle, there is a world of difference between the two.
While a corporation pays dividends with after-tax dollars, unitholders receive the cash distributed by an MLP untaxed. This is why MLPs are called ‘pass-through entities.’ Unitholders face a tax event only when they sell these units to others. This event might be weeks or decades away depending on the investor’s time horizon. Consequently, direct investment in MLPs effectively avoids the ‘double taxation.’
Great. But, we hear your question that if direct investing in MLPs were this great, why even bother investing indirectly in MLPs?
Not so fast. Direct investing comes with its own catch. Each year an investor owns units in a partnership, read MLPs, they receive the dreaded Schedule K-1 tax forms. The K-1 tax forms are substantially more complicated than the ones investors fill out to report dividends received. Adding to the complexity is the fact that a direct investor has to file a tax return in each state an MLP operates. For instance, Magellan’s energy pipeline crosses 15 states in the U.S., generating the need for as many as 15 different state filings. Finally, MLPs are responsible for paying taxes on unrelated business income (UBTI) that is generated from non-core activities.
Another way to directly access MLPs is through a specially managed account (SMA). However, this comes with an added layer of fees in the form of expense ratio and multiple K-1s. In addition to these challenges, an individual faces additional research, trading costs and tax preparation costs when investing directly in MLPs.
Whether the pros outweigh the cons in direct investment solely depends on an individual’s conditions. Direct investment in MLPs makes more sense if an investor intends to invest more than a few hundred thousand dollars.
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All Investment Vehicles Lead to MLPs
There are quite a few vehicles that can help you gain exposure to MLPs indirectly. Both open-ended and close-ended mutual funds, along with exchange-traded notes (ETNs) and funds (ETFs), can help you get a slice of the MLP.
ETNs, in particular, do a good job of replicating the returns of an MLP by matching the performance of a basket of MLPs. The UBS-TRACS Alerian MLP Infrastructure ETN (MLPI) with nearly $1.6 billion in assets is a good example that tracks the performance of MLPs listed in Alerian MLP Index. Ironically, though, many ETNs achieve this replication not by investing directly in MLPs but through managing certain debt securities. Consequently, gaining exposure to MLPs through ETNs not only generates counterparty risk but also raises concerns about what debt securities they actually hold. Furthermore, the payout from ETNs is subject to two levels of taxation, defeating one of the key reasons for investing in MLPs – to avoid double taxation.
Check out our dedicated page on MLPs.
On the other hand, while both open-ended and close-ended mutual funds have no counterparty risk, they come with the added costs in the form of expense ratios. For their part, ETFs come with the restriction of investing no more than 25% of their total assets directly into MLPs. Some MLP ETFs trade so infrequently that liquidity risk becomes an issue too.
But despite these drawbacks, the biggest selling point of indirect investments into MLPs is that all of them eliminate the need for filing K-1s. Investors who are constrained by tax preparation efforts and those with a limited portfolio might still benefit by indirectly investing in MLPs.
Are MLPs dying? Find out here.
The Bottom Line
If you ever wondered why the same business produces different investment returns with respect to MLPs, then the message is in the medium. The choice of direct or indirect investment into MLPs could make all the difference in achieving the desired investment goal.
Be sure to visit our complete recommended list of the Best Dividend Stocks.