MLP ETFs: Unfortunate Victims of The Fiscal Cliff (AMLP, MLPA, YMLP)

Eric Dutram: With the conclusion of the U.S. presidential election, a major hurdle of uncertainty is over for the stock markets and finally it seems now we can have some fundamental catalysts driving the market movements.

Unfortunately, it hasn’t exactly been a bull market since Obama won a second term, as the S&P 500 has slipped and is now heading into bear territory having breached the crucial 1400 level.

Clearly, the positive bias in the market (which was persistent through a major part of fiscal 2012) seems to be over and the markets presently are concentrating on big events such as the ‘Fiscal Cliff’ (read Volatility ETFs Winning on Fiscal Cliff Turmoil).

The induced fear of the Cliff among investors has led to sharp selling pressure in the market as worries build over taxes. In fact, rates could go up across the board with capital gains taxes and dividend rates jumping to levels unseen in at least a decade.

This is especially bad news for income seeking investors who have already seen a rough past few years. If the paltry yields on fixed income securities were not enough, now they have to deal with added tax burdens on dividends, due to the Fiscal Cliff. Thanks to this, investors have been liquidating their investments as an attempt to be taxed at current rates and then (perhaps) buy back again once they have clarity over issues pertaining to the Cliff.

From the ETF space, the MLP ETF segment seems to have been on the wrong side of this fear induced correction as the ETFs in this space are among the biggest losers in this post-election sell off. Although it must be said that this slice of the market had been enjoying a decent run this year, at least until the election results were out (see Do Country ETFs Really Provide Diversification?).

The following table highlights certain ETFs from the MLP segment and analyzes their performance in this fiscal year:

ETF Post-Election Returns Pre-Election YTD Returns YTD Returns Yield Total Assets Expense Ratio
AMLP -5.75% 0.42% -5.35% 6.01% $4.24 billion 0.85%
MLPA -7.40% 1.26% -6.23% 6.67% $15.04 million 0.45%
YMLP -11.59% -3.07% -14.31% 7.61% $80.39 million 0.82%

Note: YTD Returns for MLPA and YMLP are Since Inception Returns

Traditionally, MLP ETFs are known to be stable investment avenues primarily offering high and steady cash flow streams to investors in the form of high yields. However, they are known to offer little in terms of capital appreciation. That is the reason why we see the pre-election YTD returns are almost flat.

However, these ETFs were massively hit by the post-election sell offs. One reason could be the investors’ perception about the extremely high dividend taxation of these high yielding ETFs if we fall off the Cliff.

The table also suggests another very interesting fact. The post-election sell offs are highest for ETFs having higher yields. This suggests that the fact that the bearish momentum in the MLP ETF segment is actually a fear of paying higher taxes on higher yields (although the sample size is relatively small).

However, having a closer look at the true picture reveals a different story. MLPs distribute 90% of their income to their partners (i.e. investors) in order to avoid state and central level corporate tax, just like Real Estate Investment Trusts (REITs) (read HYEM: The Best Choice in Junk Bond ETFs?).

However, these distributions are not accountable to be taxed as and when the distributions are made, but are deferred until investment in them are liquidated. Thus form an investor point of view it in some ways gives them a head start on the tax front. Although, when the positions are liquidated the distributions are also taken into account and are taxed as capital gains.

While at the initial thought this may not seem like much of an advantage over other high yielding avenues, however, this deferral of tax might go a long way in serving the purpose of investors seeking high levels of current income while holding on to their investments in these volatile markets.

Unfortunately, the bearish momentum in the markets arising out of the fiscal cliff is treating MLP ETFs like other dividend paying avenues, however, with the passage of time as things get clearer a rally in the MLP segment seems more than evident. Also, needless to say their high yields over other dividend yielding instruments is an added advantage in this low interest rate scenario (read Long Term Treasury ETFs: Ultimate QE3 Play?).

So, is this sell off in the MLP ETF segment a result of the negative bias in the broader markets? Will the income seeking investors restore their confidence in this intriguing slice of the market? Or do the investors foresee a radical fundamental shift in this space that will tank it further?

While it is pretty difficult to answer these questions at this present moment, one thing is pretty sure; MLP ETFs will remain an excellent source for income seeking investors who chose to ride out the market volatility while enjoying a steady stream of cash flow.

Just be careful with this space as more fiscal cliff issues come out, or if any other tax changes are proposed. Clearly, this space can be more impacted than most by proposed changes and they need to be monitored closely during these types of environments.

Written By Eric Dutram From Zacks Investment Research   

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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