MASTER LIMITED PARTNERSHIPS (MLPS)

In recent years, many U.S. energy firms have reorganized their slow-growing, yet stable businesses, such as pipelines and storage terminals, into master limited partnerships, or MLPs. There are some important differences between buying shares of a corporation and buying a stake in an MLP. With MLPs, investors buy units of the partnership, rather than shares of stock, and are referred to as "unitholders."

A. There are two classes of MLP owners: General Partners and Limited Partners.

General Partners manage the day-to-day operations of the partnership. An MLP technically has no employees, so all services, from management to bookkeeping, are provided by the general partner.

All other investors are Limited Partners and have no involvement in the partnership's operations. Limited-partner units are publicly traded, while general-partner units usually are not. The general partner stake is often 2% of the partnership, though the general partner can also own limited-partner units to increase its percentage of ownership.
Companies that use the MLP format tend to operate in very stable, slow-growing industries, such as pipelines. These types of firms usually offer lower prospects for unit price appreciation, but the stability of the industries that use the MLP format means below-average risk for investors. Cash distributions usually stay relatively steady over time (often only growing at little more than overall inflation). Furthermore MLPs tend to generate income according to transport volumes not commodity prices so they are not a proxy for or correlated to, commodities.

Some benefits of MLPs include:

Relatively High Yield. Most MLPs offer very attractive yields, generally in the 6%-7% range.

Consistent Distributions Over Time. The businesses operated as MLPs tend to be very stable and produce consistent cash flows year after year, making the cash distributions on MLP units very predictable.

Capital Gains. Firms primarily switch to the MLP structure to avoid taxes. While shareholders in a corporation face double taxation--paying taxes first at the corporate level, and then at the personal level when those earnings are received as dividends--owners of a partnership are taxed only once: when they receive distributions.
There is no partnership equivalent of corporate income tax.
Cash distributions to owners often exceed partnership income, and when they do, the difference is counted as a return of capital to the limited partner and taxed at the capital gains rate when the unitholder sells. In fact the bulk of most MLP distributions are considered cost basis reductions instead of income. This portion creates no current tax.
The current benefit is that Capital Gains tax rates are lower than ordinary income. Although this may change, deferring taxes is generally considered an attractive attribute of MLPs.

Lower Cost of Capital. The absence of taxes at the company level gives MLPs a lower cost of capital than is typically available to corporations, allowing the MLPs to pursue projects that might not be feasible for a taxable entity.
General Partner Compensation Aligned with Limited Partners' Interest. Most general partners are paid on a sliding scale, receiving a greater share of each dollar of cash flow as the limited partners' cash distributions rise, giving the general partner an incentive to increase limited-partner distributions.

B. There are of course certain downside risks to MLPs that should be considered.

Personal Tax Liability. Each unitholder is responsible for paying his or her share of the partnership's income taxes, which can make filing taxes more complicated. This is particularly true for larger unitholders, who may have to pay taxes in the various states in which the partnership operates. Moreover, limited partners might owe taxes on partnership income even if the units are held in a retirement account.

IRA or Tax Deferred Plans. MLPs may trigger taxation in these types of accounts.

Limited Pool of Investors. MLPs face a smaller pool of potential investors than traditional equities because institutional investors, such as pension funds, are not allowed to hold MLP units without incurring tax liability. These large investors do not ordinarily pay taxes, so they tend to shy away from MLPs.
Institutional investors represent the majority of investor dollars in the market, so eliminating them reduces the potential demand for MLP units. Congress recently approved a provision allowing mutual funds to buy MLPs, which should dramatically increase the number of potential investors.

C. Ways to gain exposure to MLPs

Investors in search of higher income have the opportunity to allocate a portion of their taxable portfolio to MLPs and they can do it in several ways.

Purchasing direct MLPs
Purchasing an index of MLPs
 

When looking to an index, as is the case for all index investments, investors are able to diversify away single company risk. MLP indexes offer this benefit as well as unique additional tax benefit. Investors in MLP indexes receive the cashlfow from the pool of MLPs in the index. MLP Index investors have a tax advantage over direct investors in MLPs. Direct investors are actually limited partners of the MLP and therefore receive K1s making tax preparation more complex and potentially more costly. When buying AMJ the investor buys shares which receive the pass-through income which is then reported on a 1099 form, far easier to deal with than the K-1 form used by limited partnerships.

One MLP Index worth mentioning is the JPM Alerian MLP Index Exchange Traded Note (Symbol AMJ). 10 shares of AMJ equal the Alerian MLP Index, which is about 290. AMJ owns units in MLPs allowing the fund to emulate the Alerian MLP Index.
The Alerian MLP Index has a superb track record. In 14 years, it has tripled with a modest to low beta and it's only 15% below the record high reached in 2007. The comparable Alerian index including reinvested income has grown almost 8 times its original value. Currently, the yield on AMJ is approximately 6.5%.

This Product appears to have been issued less than one year through JPMorgan, however that is not entirely true. When JPM acquired Bear Stearns, this MLP Index Note was a Bear Stearns product. It is now securely anchored by JPM, and since these type of ETNs carry the credit risk of the issuer, with JPM clearly a top credit within the global financial services space, the credit risk looks to be acceptable.

Below is a graph of the historical performance of the Alerian MLP Index.

The graph below compares the MLP Index to the S&P 500. Notehworthy here is the inverse relationship between the MLP Index and the SP500 during the period 2000-2003, a time similar to the current environment where interest rate policy was stimulative.

Also interesting is the performance of the MLP Index during the years 2003-20006 which were post Tech Bubble and September 11th periods of low then rising interest rates. MLPs during these years showed no correlation to bonds (as expressed by the BNY Intermediate Bond Index symbol MIIDX) where total returns for bonds were relative flat.

The conclusion is that MLPs offer a compelling case for portfolio diversification for specific types of qualified investors. MLPs have a lower standard deviation than broader equity markets and show little correlation to fixed income markets making them very attractive during periods of lower interest rates.

With the ability to allocate capital to the MLP space through index alternatives, investors can easily diversify away MLP specific risk and what was once a more complicated investment from the perspective of tax reporting has now become much more simplified.