First in Simplified MLPs Arrives, With Tradeoffs

As Master Limited Partnerships get easier, overinvestment and even tax consequences remain a worry.
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NEW YORK (TheStreet) -- Master Limited Partnerships have long been investor favorites for their high yields and relatively stable price appreciation. They have also been complicated investments due to a partnership structure that creates a favorable tax status for the companies, causes payouts to be treated as unrelated business taxable income and triggers a K-1 tax form, even for tax-deferred accounts, instead of the more typical 1099 form.

The exchange-traded product industry has tried to offer access to the MLP space, thus far only having offered exchange-traded notes -- not actually baskets of stocks, but instead unsecured debt instruments that promise to track the targeted index. The debt structure of ETNs is not ideal for many investors, but now investors interested in the space but who would rather not pick an individual name can buy the

Alerian MLP ETF

(AMLP) - Get Report

.

The fund does several things, including eliminating the K-1 form, sending out a 1099 instead. Per the Alerian website: "All K-1s are received and processed by the Alerian MLP ETF. The Alerian MLP ETF distributes a single Form 1099 to its shareholders." I would note that in an Aug. 25 interview on CNBC, CEO Kenny Feng disclosed not having an IRS ruling on this process.

There is one more point on the taxation issue: Individual MLPs get tax benefits that do not easily fit into an exchange-traded fund. The Alerian MLP ETF provides easier reporting by being able to issue a 1099, as mentioned above, but the tradeoff is that "to achieve ETF status, AMLP had to give up its 'pass-through status' and be taxed as a corporation," according to Ron Rowland of

investwithanedge.com

. This means the fund will have to pay taxes on the income from the underlying MLPs, which Rowland notes will be a drag on performance. Anyone interested in the fund will need to weigh the benefit of not having to select one stock to invest in versus as-yet unknown drag from the tax consequences.

Looking under the hood, the fund has 25 holdings and allocates large percentages to some of the better-known companies in the space.

Enterprise Products Partners

(EPD) - Get Report

weighs in at 9.5% of the fund,

Kinder Morgan Energy Partners

(KMP)

at 9.3%, and four other companies have close to 7% weightings.

The big attraction of MLPs is the yield paid by most of the companies in the space. Alerian expects the MLP ETF to yield 6% to 6.5%. MLPs also tend to be less volatile than the broad market but still offer price appreciation. The three largest components of the ETF are each up 10% to 15% year to date versus a 6% decline in the

S&P 500

. The business of the underlying companies is to transport oil or gas through pipelines and collect a fee for doing so. The business model is such that the companies are not dependent on the price of the products transported, but instead on the volume transported, and historically volume has been less volatile than price.

High yields, low volatility and good price appreciation would appear to be a nirvana of sorts for investors, resulting in their tremendous popularity of late -- and, as mentioned, a proliferation of products. This pattern of a segment doing well, followed by investor demand, followed by products created to meet demand, has happened many times in the past, and usually the next steps are bad: Supply exceeds demand, prices go down and many investors feel regret for having had too much exposure.

We've seen this in the past 10 years with Internet stocks and covered call funds. This is not to compare

Magellan Pipeline Partners

(MMP) - Get Report

at 7% of the MLP ETF with Pets.com, but to point out an investor/investment industry psychology that is comparable. Also of note, given the current favor MLPs have, is that they can go down when the market goes down. During the worst of the panic of 2008 and early last year, several of the component holdings went down 40%. That was better than the market, but still a lot.

Every segment of the market has risk or can have something otherwise go wrong. Four years ago the Canadian version of MLPs got crushed on news of a tax status change. Some sort of unexpected news can hurt any part of the market, including MLPs, and while moderate exposure for all the reasons mentioned above does make sense, too much of anything becomes risky. MLPs are not immune.

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At the time of publication, Nusbaum had a client holding KMP, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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