Posted by on Oct 12, 2015 in Articles & Advice, Blog, Columns |

Image Credit: Christophe Vorlet

By Jason Zweig | 2:49 pm ET  Oct. 9, 2015

Investors in master limited partnerships have just gotten the jolt of a lifetime.

The Alerian MLP Index, a leading measure of the performance of these income-paying energy companies, fell 5.7% on Sept. 28 and another 5.8% the next day. At that point, the index was down 22% for the month and 36% for 2015. Then, over the next week, it shot up 20%.

That bone-shaking volatility is just the latest evidence that there’s a huge difference between understanding your investments and thinking you understand them.

MLPs, most of which produce, transport, refine and store oil and natural gas, have been one of the hottest vehicles offering higher income to yield-famished investors. For the 10 years through 2012, according to Alerian, energy partnerships generated an average yield —income divided by price—of 7%. Their total return—income plus changes in market price—averaged 16.5% a year.

Funds that hold baskets of MLPs have soared in popularity. Investors pumped $16.5 billion into these funds last year, according to research firm Morningstar—sending total assets to a peak of $52 billion, up more than threefold from year-end 2012.

Such hot money almost always goes down in flames.

The Alerian MLP index fell 15.3% last month—the third-worst monthly loss in its nearly 20-year history. The average MLP mutual fund, according to Morningstar, lost 15.8% for the month. ETFs fell 16.3%.

What caused the collapse?

Last month, the price of oil fell 8%. Although many partnerships charge flat fees for their services that don’t vary with the price of oil, the sharp decline was still scary.

Meanwhile, growing numbers of skeptics were warning that energy partnerships are overvalued and might not keep paying out income at their historical rates.

Traditionally, many investors held energy partnerships largely for their unusual tax benefits; if you buy shares or “units” in an individual MLP, tax law permits you to defer paying income tax on their generous dividend payments pretty much indefinitely. That advantage comes at the cost of having to fill out a lot of extra paperwork.

However, many newer investors have instead been pursuing growth, says Kenny Feng, president of Alerian, a Dallas-based firm that researches the sector. That’s made the partnerships more volatile.

“If you treat MLPs like anything else, rather than a special asset with favored tax treatment, then you’ll probably end up committing the same buy-high-sell-low behavior as other investors elsewhere,” he says.

Finally, as my colleague Laura Saunders and I warned in 2013, MLP mutual funds and ETFs can negate the tax advantages of owning the partnerships directly.

Mutual funds, closed-end funds and ETFs that hold at least 25% of their assets in MLPs are taxed as corporations. That spoils the valuable tax deferral of the MLPs themselves. Those funds must set aside 35% of their income and unrealized gains as a “deferred tax liability” (plus typically about 2% for estimated state taxes).

That normally has the effect of buffering both positive and negative returns, leading the typical MLP fund to underperform the partnership market on the way up and to outperform on the way down.

But when all of an MLP fund’s unrealized gains disappear, the tax liability does too—and the value of the fund will then drop dollar for dollar with its holdings. That appears to have occurred at several MLP funds during September, says Simon Lack of SL Advisors, an asset manager in Westfield, N.J.

If you bought an MLP fund when they were hot, consider getting Uncle Sam to eat your losses.

Selling the fund at a loss and putting the proceeds into one or more individual MLPs is “absolutely a good idea,” says Robert Gordon, a tax strategist and president of Twenty-First Securities.

Mr. Lack regards Energy Transfer Equity, Enlink Midstream LLC and Targa Resources Corp. as conservatively run and capable of sustaining their income payments.

Or you could keep the proceeds in cash or Treasury Inflation-Protected Securities. Unlike oil or gas wells, those reservoirs of safety should never run dry.


Source: The Wall Street Journal