The Next Bubble: MLPs

TheStreet.com, Fall, 2013. This article was written with Oliver Pursche, the Co-Portfolio Manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with thestreet.com to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

Over the past few years, investors have flocked to master limited partnerships like mosquitos to fire, and in my view, they could get burned if they aren’t careful.

It’s easy to see the appeal: purveyors of MLPs will point to the high yield and tax advantages. The story, however, is far more complicated, and as is often the case, riskier than described.

In case you aren’t familiar with MLPs, essentially they are partnerships that are publicly traded. Investors in MLPs, like any other partnership, are considered unit holders.

Most MLPs, although not all, earn the majority of their income from energy-related companies — think oil or natural-gas pipelines and you’ve pretty much got it.

In fairness, I have never been a big fan of MLPs, or any other investment that returns my own principal and calls it income. After all, if it’s my money that is being sent to me, it’s hardly fair to call it income.

So far, while interest rates have continued to trend downward, and financing for these companies has remained cheap, the risks of the investment haven’t been outsized.

Caution Signs

With the likelihood of rising rates increasing, additional regulatory scrutiny and changing demand for use of energy — both in terms of quantity as well as type, the risks for these vehicles are mounting.

Let’s start with the most obvious (and annoying) — K1s. If you invest in an MLP, you won’t receive a 1099, you will get a K1 which is likely to be taxed very differently and without the benefits of any potential offsetting deductions.

Second, a part — sometimes as much as half — of the distribution you receive is actually a return of your own principal — in other words, the actual yield is much lower than promoted.

Third, given the lower “real” yield that is produced, as interest rates rise, the attractiveness of the income potential of MLPs is likely to decline.

Lastly, and in my opinion most significantly, the world’s demand for energy is changing. While oil continues to be in high demand today, natural gas is becoming more available and is being used more prevalently. With this, and any other changes in energy demand that may come in the future, the reliability of the MLP has to be questioned.

As with any investments, MLPs have their merits, and could be suitable for a portion of your portfolio. But you better make sure you understand what you are buying and where the risks are.

Remember what countless successful investors such as Warren Buffett, Bill Gross, and Peter Lynch have said time and time again — If you don’t understand how an investment works or what it does, don’t invest in it. Words to live by, if you ask me.