How to Buy MLPs: Individual MLPs vs. MLP ETFs

Master limited partnerships have become wildly popular over the past decade, and it’s easy enough to see why. Collectively, they are the highest yielding major asset class available, and the 10-year cumulative total returns are an eye popping 328%, as measured by the Alerian MLP Index. (And yes, those returns include the carnage of 2008 and early 2009.)

Still, a lot of investors are intimidated by MLPs because of their perceived complexity. They shouldn’t be. While the tax issues aren’t fun, that’s what TurboTax and CPAs are for.

This brings me to the crux of this article. A host of ETFs, ETNs and mutual funds have cropped up to satisfy investor demand and provide an “IRA-friendly” alternative. The JPMorgan Alerian MLP ETN (AMJ) is the largest and most popular, but the ALPS Alerian MLP ETF (AMLP) and Oppenheimer SteelPath MLP Income Fund (MLPDX) are also popular options.

Today I’m going to go over the pros and cons of investing in these funds vs. building a portfolio of individual MLPs.

Diversification

For instant diversification, you have to go with a fund … but most funds are not as diversified as you might think. The top 10 holdings of the Alerian MLP Index — which serves as the benchmark for many MLP funds and includes companies such as Enterprise Products Partners, LP (EPD), Kinder Morgan Energy Partners, LP (KMP) and Plains All American Pipeline, LP (PAA) — account for 61% of its market cap. The top 15 holdings account for 72%.

Most investors — particularly if they are long-term income investors — would have no problem buying 10 to 15 individual MLP holdings. And with online trading commissions generally lower than $10 per trade these days (and given that dividend reinvestment is often free), it’s not cost-prohibitive to do so.

Cost

This brings me to the next consideration: cost.

Most MLP funds are maddeningly expensive to own. Both AMJ and AMLP — which are passive index products — have expense ratios of 0.85%, which is nearly as much as you would expect to pay for active management. MLPDX’s expense ratio comes in at 1.35%.

Given that most investors buy MLPs for their yield — and given that a “decent” MLP yield these days is 5%-6% — an 85-basis-point haircut is going to be felt.

Let’s take a look at some numbers. In a $100,000 MLP portfolio split across 15 individual holdings, you would pay $150 or less in trading commissions to get started. If your broker allowed for commission-free dividend reinvestment, you would have no additional costs. Ever. That same $100,000 invested in AMJ or AMLP would cost $850 per year to own, every year you own it.

Taxes

This is where it gets messy.

MLPs avoid corporate taxes by being organized as partnerships. In a nutshell, this means they have 35% more cash at their disposal to distribute, which is why MLPs are able to offer such high yields. But because MLPs generate “unrelated business taxable income,” they should never be held in an IRA account. Doing so can create a tax nightmare in which you have to file a separate tax return for your IRA.

And there is really no advantage to putting an MLP in an IRA. MLP distributions are generally not taxable for the first several years of ownership due to large non-cash expenses that cause the distributions to be classified as “return of capital” rather than current income. These have the effect of lowering your cost basis and thus raising the capital gains taxes you’ll owe when you eventually sell. Once your cost basis reaches zero — which might take multiple decades — your distributions are fully taxable at your marginal tax rate. It’s a pretty sweet deal.

The taxes on MLP funds will make your head swim. The distributions made by AMJ are considered bond interest by the IRS and are thus taxed as ordinary income. And AMLP, in a departure from normal fund tax structure, opted to be structured as a corporation and pay taxes at the corporate level. This has the effect of making its effective expense ratio of nearly 5% as opposed to the quoted 0.85%.

I see no reason to ever own AMLP.  And AMJ is generally the “least-bad” option for investing in MLPs within an IRA.

My advice? Hold your regular MLPs in a taxable account and learn to tolerate the annual K-1 tax forms. It’s an annoying headache, but you’ll enjoy higher returns and pay less in taxes and fees. If you are limited to IRA investing, then go with AMJ or a substantially similar security. In IRA accounts I manage, this is precisely what I do.

There is one exception I should note. MLP general partners are often structured as corporations and are thus able to be held in IRA accounts with no complications. General partners can be thought of as “leveraged” MLPs because of their incentive distribution rights. Without getting into the nitty-gritty accounting details, the general partner gets a larger share of the payout every time an MLP raises its distribution.

Two general partners I own and recommend are Kinder Morgan Inc. (KMI) and Williams Cos. (WMB). Both have been dividend-raising monsters in recent years and sport current yields of 4.5% and 4.2%, respectively.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he was long EPD, KMP, PAA, AMJ KMI and WMB. Click here to learn about his top 5 global investing trends and get your copy of “The Top 5 Million Dollar Trends of 2013.”