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Mastering the MLP Domain


MLPs have handily trounced both the Dow Jones Industrial Average and S&P 500 Index since the start of the millennium. But there's a hornet's nest of hidden costs the investor has to consider.

The relevant paperwork, not plain vanilla 1099s but instead a form called K-1, clocks in at a deceptively simple two pages, but that hides a hornet's nest of ensuing complications. (Under "Other information, number 20, subsection D, did you duly list all "qualified rehabilitation expenditures" per the partner's instructions? Not including rental real estate, of course.)

Moreover, as myriad MLPs have pipelines crisscrossing several states, tax liabilities can be incurred all over the map irrespective of where the owner actually resides. Hence when it actually comes time to sell, specialist advisers must invariably be brought on board to decipher arcane issues including passive loss carryovers and flow-through accounting. When each costs up to $500, the cost of such experts can quickly mitigate many potential profits.

It also bears mentioning that master limited partnerships, much of whose income is already tax deferred, are by definition unsuitable in retirement products such as IRAs and 401 (k )s. Indeed, owning an MLP in such an account can also subject the holder subject to dreaded Unrelated Business Taxable Income (UBTI), a levy that often amounts to over $1,000 annually.

Enter the ETF

In recent times, a rebellion against the sheer volume of tax paperwork involved in owning individual MLPs has seen an exponential growth in industry exchange traded funds, exchange traded notes, and closed end funds. Examples include ALPS Alerian MLP ETF (AMLP), JPMorgan Alerian MLP Index ETN (AMJ), and Credit Suisse Cushing 30 MLP Index ETN (MLPN).

By buying a basket of MLPs as opposed to specific names, investors can at a stroke eliminate the burdensome K-1 issue, as Uncle Sam simply treats these distributions as regular dividends. After the parent fund company pays the piper at the corporate level, a single 1099 is all individual stakeholders need concern themselves with. As an added benefit, such investments are also allowed in tax-deferred retirement vehicles.

Of course, as with anything in the MLP arena that may appear too good to be true, the reward carries a risk, in this case fund fees of up to 200 basis points that can quickly erode portfolio value.

Bull case

Proponents of MLPs have plenty to point to. In the popular industry parlance, assets are often likened to turnpikes or toll roads, in that they provide a relatively safe and steady income stream derived from fixed fees. Indeed, about 65% of industry revenue comes from such long-term contracts. Stable cash flow, recurring revenue, and consistent payouts offer an attractive safe haven appeal, especially in the current turbulent investing climate.

Moreover, MLPs typically exhibit less volatility than many other assets and also tend to be less correlated with other market sectors, an important factor for investors in search of diversification. The opportunity to accrue tax deferred income is another advantage, especially with the "fiscal cliff" looming ever closer. America is also currently experiencing an unprecedented energy boom, with outfight independence no longer a pipe dream.
No positions in stocks mentioned.
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