At this point, it's no secret that interest rates are terrible for savers. As the Federal Reserve has kept short-term rates low in order to spur the economy, many traditional income sources have come up dry. Money market funds, CDs and short-term bond funds like the Vanguard Short-Term Bond ETF (ARCA:BSV), all now pay next to nothing. To that end, investors wanting to live off their savings have been forced to look at some non-traditional choices. Master limited partnerships (MLPs) have exploded in popularity over the last few years, given their high yields. However, they aren't without their own tax headaches. For investors, the recent exchange-traded products boom has allowed retail portfolios to tap the asset class without many of these nuisances.
While once a quirky asset class reserved for the wealthy, master limited partnerships have made it to the mainstream. Investors have clamored over the security type as yields continue to be paltry. Based on their corporate structure, MLPs pass on the bulk of their revenue to investors via big distributions. This is similar to real estate investment trusts (REITS). Unit holders are rewarded with 6-7% average dividend yields and some other tax advantages. As Investors have flocked to them in droves, the Alerian MLP index, which tracks fifty energy-based partnerships, returned more than 14% during 2011. That compares 2.1% for the broad S&P 500, when including dividends.
However, while MLPs provide hefty income, they do come with some special considerations. Because MLPs distribute not only dividends but also write-offs for their asset depreciation, instead of receiving a standard 1099 form, investors can expect a K-1 statement in the mail. While K-1's aren't too complicated, it does add another layer of frustration come tax time. In addition, since many pipeline MLPs do business in a variety of states, there is the potential for investors to have quite a bit of extra paperwork. Finally, MLPs come with the touchy subject of unrelated business taxable income (UBTI). Depending on the amount of distributions investors receive and what kind of account the MLP units are domiciled in (like an IRA), investors could be required to file additional tax returns and make extra payments. While this is rare, it is still something to consider.
Betting on the Sector with ETPs
With analysts predicting that strong MLPs will raise their distributions by 5 to 8% during 2012, investors may want to add the sector to an income portfolio. However, given the potential tax headaches, investors may want to opt for one of the various exchange traded products that track the space. These broad-based funds offer flexibility and diversification benefits, big distributions as well as eliminating those nasty K-1's. Here are a few picks.
The Alerian MLP Index ETN (ARCA:AMJ) is the behemoth in the sector with over $4 billion in assets, and is sponsored by J.P Morgan (NYSE:JPM). The exchange traded note tracks 50 different MLPs across a wide range of sub-sectors including pipeline specialist Kinder Morgan Energy Partners (NYSE:KMP) and shipper Teekay Offshore Partners (NYSE:TOO). Shares of the ETN currently pay a quarterly coupon distribution of 4.74% and charges 0.85% in expenses. Tracking the same index, but structured as an ETF is the ALPS Alerian MLP ETF (ARCA:AMLP). The fund is unique as its structure allows for the preservation of holdings tax breaks on income. However, the fund has to pay corporate taxes, which can be a major drag on performance in booming years. Nevertheless, the ALPS fund does eliminate the counterparty risk associated with the ETNs.
While the previous two funds hold the bulk of the assets in the sector, they aren't the only choices. E-TRACS Alerian MLP Infrastructure ETN (ARCA:MLPI), issued by UBS (NYSE:UBS), hones in on the pipeline, storage and gathering terminals that dot the country. The fund represents a pure bet on America's important energy infrastructure. Likewise, the Credit Suisse Cushing 30 MLP Index ETN (ARCA:MLPN) follows an equal-weighted strategy to produce returns. The two ETNs yield 5.78 and 5.11%, respectively.
The Bottom Line
For investors looking for income, master limited partners remains a top choice. However, their stable and high distributions can come with some nasty tax headaches. To that end, portfolios may be better suited in on the sectors various exchange traded funds. The previous picks, along with the Morgan Stanley Cushing MLP High Income ETN (ARCA:MLPY) make ideal selections to play the sector's rich dividends.
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.