The U.S. energy renaissance is a big reason master limited partnerships, also known as MLPs, have been one of the more attractive alternative investment opportunities in recent years. Says Dan Dittler, a research analyst with Fidelity who specializes in MLPs: "The domestic oil and gas boom is the most important tailwind for the long-term outlook of the MLP industry."
So, how can investors gain exposure to MLPs? Exchange-traded funds (ETFs) offer several advantages, and, depending on your investment objectives, risk tolerance, and tax situation, exchange-traded notes (ETNs)1 or mutual funds that hold MLPs might be worth exploring as well. However, MLPs are complex investing vehicles that require additional research and have added risks. ETFs, and especially ETNs, also have unique risks and investment characteristics. If you are willing to do the research and are comfortable with the potential risks, read on to find out which investment vehicle for investing in MLPs may make sense for you.
MLPs in demand
What are MLPs?
It is highly recommended that you fully understand the benefits and, more importantly, the risks of investing in master limited partnerships. Read here.
The International Energy Agency forecasts that the United States will become the largest producer of energy by 2020, surpassing Saudi Arabia.2 "Ongoing oil and gas production growth is being driven by more economic drilling technologies," Dittler observes. "The increasing volume of available oil and gas being found in the U.S. requires more infrastructures to store and transport the product, and MLPs provide an excellent solution."
In addition to the domestic energy renaissance, the potential tax advantage and high yield that many MLPs offer have helped propel these securities to outperform the broad market. "MLPs offer an attractive dividend yield, relative to many other investments," says Joanna Bewick, portfolio manager of the Fidelity® Strategic Dividend & Income® Fund (FSDIX) and Fidelity® Strategic Real Return Fund (FSRRX). Given the historically low interest rates offered today, a steady income stream has been in high demand by many investors—and many MLPs have benefited as a result.
Could MLPs be a flash in the pan? Not likely. Consider that the Alerian MLP Index (AMZ) had outperformed the S&P 500, on a total return basis, for 12 straight years until 2012. Note that the return on an MLP can include a return of capital. According to Bewick, that streak ended last year because of "fiscal cliff negotiations that investors feared might alter the beneficial tax structure of MLPs." Indeed, legislative risk is a factor to keep in mind with regard to MLPs. But with the fiscal cliff negotiations in the rearview mirror, the Alerian Index has rebounded sharply this year, rising more than 11% on a price return basis as of mid-June, 2013.
Investing in MLPs
There are several ways that investors can gain exposure to MLPs. A few of the largest publicly traded individual MLPs by assets are Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), and Magellan Midstream Partners (MMP). And more MLPs have been coming down the pipeline as the U.S. energy boom has helped spur their creation.
It is also possible to purchase MLP ETFs. An MLP ETF can enable an investor to diversify away some of the business risk that might be associated with investing in an individual MLP, while providing some of the potential tax benefits that an exchange-traded product (ETP) offers, at a relatively low cost.3
Do your research, however, as certain MLP ETFs can be pricey. "Most new MLP funds have had tremendous success raising capital," Dittler says, but he sounds a note of caution. "Because of the strong demand for these investments, many existing MLP ETFs are trading at a premium to their underlying NAV." One concern here is that there is no guarantee any premium will persist.
Also, some ETFs do not track their target benchmark as closely as you might want. A good way to determine this is to assess their tracking error, which is the difference in price between the fund and the benchmark it is attempting to track. A widening tracking error could be a warning sign. You can find an ETF's tracking error by searching for a ticker on the ETF snapshot page on Fidelity.com.
If you are interested in researching MLP ETFs, a couple of the largest ones by net asset value are the Alerian MLP ETF (AMLP) and the First Trust North American Energy Infrastructure Fund (EMLP).
Another type of exchange-traded product that investors can purchase to gain exposure to MLPs is an exchange-traded note (ETN). ETNs are unsecured debt obligations. Two of the largest ETNs by net asset value are the Barclays ETN + Select MLP (ATMP) and the iPath® S&P MLP ETN (IMLP).
ETNs may be attractive to certain investors because they typically eliminate the tracking error associated with ETFs, while retaining some of the potential tax advantages that ETPs and MLPs can provide.4 Yet ETN MLPs have their own unique disadvantages. Because they are unsecured debt obligations, these types of securities are subject to greater credit risk than ETFs, potentially increasing the overall risk of such an investment.
Also, the after-tax yield for ETNs may be less attractive than ETFs holding similar assets. The tax treatment of these products is complex, so be sure to consult a tax adviser before taking any action.
While MLP ETFs and ETNs can offer the advantages of exchange-traded products, mutual funds that hold MLPs may be a strong alternative for some investors.
Investing in MLPs using mutual funds allows the investor to delay paying taxes on any distributed income until the investment is sold, potentially enabling any gains to qualify as long term (which are taxed at a lower rate than short-term capital gains).
Another advantage is that actively managed mutual funds can help limit some of the risks that could be present with different MLPs, and of which the investor might be unaware. "I believe the biggest misconception in MLP investing," Dittler says, "is the notion that all MLPs are created equal." In fact, the business models of MLP operators can vary widely across the industry, creating the possibility of increased risk specific to that business. "Some companies may take on significant commodity risk, for example—more than individual investors may realize," notes Dittler.
Mutual funds may be constructed to differentiate among the various MLP business models. By this action, investors might be able to actively manage some of the risk. Of course, mutual fund investors will be paying a management fee for this benefit. Furthermore, certain funds may be restricted as to how much of the fund can be invested in structures like MLPs.
Opportunities in MLPs
Dittler believes there will be an increasing amount of oil- and gas-linked MLP opportunities in the years to come. Investors who are interested in MLPs should determine what the best vehicle may be to gain exposure to these in-demand securities.
Before investing, consider the funds' objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Past performance is no guarantee of future results.
The tax and investment information contained herein is general in nature, is provided for informational purposes only, and should not be construed as investment, legal, or tax advice. Fidelity does not provide investment, legal, or tax advice.
Investments in publicly traded MLPs involve risks and considerations that may differ from investments in common stock:
Tax complexity risk: Master Limited Partnerships (MLPs) are generally considered pass-through entities for tax purposes and have special tax considerations. Pass-through entities may generate unrelated business taxable income (UBTI) that may have undesirable tax consequences for retirement accounts and other tax-exempt investors. If you hold MLP units, you are generally treated as a partner for tax purposes and will be issued a Schedule K-1 (Form 1065) rather than a Form 1099 for use in filling out your tax return. A K-1 lists the partner’s share of income, deductions, credits, and other tax items. If the MLP has operations in multiple states, you may need to file a separate tax return in each state.
An MLP that is treated as a corporation in the United States rather than as a pass-through entity for federal income tax purposes would be obligated to pay federal income tax on its income at the corporate tax rate. In this case, the amount of cash available for distribution by the MLP would be reduced and part or all of the distributions made could be taxed entirely as dividend income. In this case, a Form 1099 would be furnished rather than a Schedule K-1. Please see the MLP’s Web site, SEC filings, or most recent shareholder report for further details about tax treatment of your investments.
Legislative risk: The tax treatment of publicly traded MLPs could be subject to potential legislative, judicial, or administrative changes, possibly on a retroactive basis. Any such changes in tax treatment could negatively impact the value of an investment in an MLP.
Concentration risk: Many MLPs are concentrated in the energy infrastructure sector. This narrow focus of MLPs may present considerably more risk than a diversified investment across numerous sectors of the economy.
Market risk: MLPs may exhibit high volatility, particularly during periods of economic stress or due to other events impacting the particular sector or industry in which an MLP operates.
Interest rate risk: The market prices of MLPs are sensitive to changes in interest rates. As interest rates rise, the prices of MLP units may decline (and vice versa). Rising interest rates could also increase the MLP’s cost of capital, which may limit potential growth through acquisition or expansion and reduce distribution growth rates.
Distribution policy risk: All or a portion of an MLP’s distribution may consist of a return of capital from your original investment. MLP unit holders should not assume that the source of a distribution is net profit from the MLP’s operations.
Liquidity risk: Despite the fact that MLPs are publicly traded, investments in MLPs may be relatively illiquid due to their unique investment strategy, asset concentration, or other factors. Lack of liquidity can negatively impact your ability to sell MLP units. Additionally, should a secondary market exist, investors who need to sell MLP units may be subject to a significant loss.
Commodity price risk: The price of MLP units may be negatively impacted by fluctuations in commodity prices. A significant decrease in the production or supply or sustained reduced demand for natural gas, oil, or other energy commodities would limit revenue and cash flows of MLPs and, therefore, the ability of MLPs to make distributions to unit holders.
Regulatory risk: The assets of MLPs tend to be heavily regulated by federal and state governments. Changes in regulation can adversely impact an MLP’s profitability and therefore the value of MLP units.
Conflicts of interest: The general partners of an MLP typically have limited fiduciary duties to the MLP and may have conflicts of interest, which could result in the general partners favoring their own interests over the MLP’s interests. Fidelity cannot guarantee that such information is accurate, complete, or timely.
Exchange traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risk, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of ETNs). Each ETP has a unique risk profile that is detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.
The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
1 Exchange-traded notes (ETNs) are not exchange-traded funds (ETFs). Unlike ETFs, ETNs are unsecured debt subject to the issuer's credit risk; ETNs do not provide an ownership interest in any underlying assets. Many ETNs are intended for short-term trading and may not be appropriate for an intermediate or long-term investment time horizon. ETNs may be thinly traded, can become illiquid, and may trade at a market price significantly different (a premium or discount) from their indicative value. ETNs may exhibit extreme market price movements, which can occur quickly and unexpectedly. Some ETNs are callable or redeemable by the issuer before their stated maturity date. In the event of early redemption, you are likely to lose all or a part of your initial investment. The tax treatment of ETNs is uncertain and may vary from that described in the prospectus.
2 Source: IEA.org.
3 There can be significant taxation complexities associated with MLP ETFs and other exchange-traded products. Consult a qualified tax advisor before purchasing such a security.
4 Although an ETN provider generally issues or redeems shares to meet customer demand, it is generally not a requirement. ETN providers may, at their discretion, based on market conditions, regulatory developments or other factors, suspend issuance of new shares. Limitations on new share issuance may cause an imbalance of supply and demand in the secondary market, which may cause the ETN to trade at a market price significantly different from its indicative value (premium or discount).
The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships and it is calculated using a float-adjusted, capitalization-weighted methodology.
The S&P 500® Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Indexes are unmanaged and you cannot invest directly in an index.
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