Despite the hype, MLPs still have risks

By Helen Kearney

NEW YORK (BestGrowthStock) – Investors in search of a decent yield are piling into master limited partnerships (MLPs), creating a concern among some advisers that there may be a bubble forming in this once quiet segment of the market.

A range of new exchange-traded products and mutual funds has made it easier than ever for retail investors to access MLPs.

“The floodgates have opened,” said Bill Parsons, a financial adviser at Scottsboro, Alabama-based Mainsail Asset Management. “But ultimately it’s a small-capacity asset class and it’s limited as to how much money can pile in.”

The market capitalization of MLPs is currently around $193 billion, up from just $71 billion in 2005, according to Wells Fargo & Co (WFC.N: ).

The attraction is easy to see. These publicly traded partnerships, which are mostly invested in the energy sector, provide investors with relatively high and predictable cash distributions. The majority of the distributions are tax-deferred until the investor sells the shares.

The average yield on MLPs is currently around 5 to 7 percent, versus 2.5 percent for 10-year Treasuries. MLP yields are projected to grow by 5 percent per year, according to Morningstar Inc (MORN.O: ).

Still, this is not the place for bargain-hunters. During the downturn, the Alerian MLP Index, which tracks 50 of the largest energy MLPs, more than halved in value, trading at $152 in November 2008. It is now back up to around $320. Morningstar analyst Jason Stevens believes the investments are now fairly priced.

A range of new financial products is likely to create even more interest in MLPs.

Last week, Alerian launched the first MLP exchange-traded fund designed to track the Alerian MLP Infrastructure Index. This follows the MLP exchange-traded notes (ETNs) unveiled by both UBS (UBSN.VX: ) and Credit Suisse (CSGN.VX: ) Cushing earlier this year, which provided some competition to JPMorgan Chase & Co’s (JPM.N: ) ETN launched in April 2009. SteelPath Fund Advisors also launched the first MLP open-ended mutual funds in March.

The expense ratio on the ETF and ETNs is 0.85 percent, while the mutual funds charge around 1 to 1.5 percent.

By using exchange-traded products and mutual funds, investors also avoid the tricky tax forms, (a K1 instead of the usual 1099) that direct investors in the partnerships receive.

Parsons, the Alabama-based adviser, is concerned that a rush of new retail investors may drive yields lower while increasing risk. Institutional investors tend to avoid MLPs due to tax complications.

“They’re hot right now and they’re attracting a lot of money, but retail investors are fickle and can sell in a panic,” said Parsons, who invests selectively in MLPs.

All of the hype has also given some investors the false impression that MLPs are risk free, Parsons added.

As MLPs distribute the majority of their earnings to their shareholders, they rely heavily on being able to tap the credit markets to fund new projects. When the markets froze, the investments plunged.

Morningstar’s Stevens described the threat of another credit crunch as the “sword that hangs over the head of MLPs.” Still, he added that during the downturn, the majority of MLPs managed to maintain their distributions to investors, in contrast to a number of companies that cut or eliminated their dividends.

Lee Munson, an adviser at Albuquerque, New Mexico-based Portfolio LLC, said MLPs are the “secret sauce” of his clients’ portfolios and he invests around 10 to 25 percent of an average portfolio in the assets. But he also preaches caution.

“Everyone is talking about them but this is a tiny market and it’s misunderstood,” he said.

Munson recommends sticking to large cap offerings as smaller partnerships can be volatile and are more likely to cut their distributions.

He and Parsons both agree that while MLPs can provide a nice income stream it is essential to diversify client portfolios.

“It has been an important asset class,” said Parsons. “But at the end of the day, it’s not a silver bullet so make sure you don’t overallocate.”

(Reporting by Helen Kearney, editing by Dave Zimmerman)

Despite the hype, MLPs still have risks