Leveraged ETN of Master Limited Partnerships: Taxes Galore and Risky

Leverage is extremely dangerous.

 – Ben Shepherd, Global ETF Profits

I love energy master limited partnerships (MLPs).  I wrote very favorably about them last month and continue to believe that they offer the absolute best combination of high yields and tax advantages. As Elliott Gue, co-editor of the MLP Profits investment service, recently wrote:

Master limited partnerships (MLP) followed the S&P 500 and other global markets lower in May. But since late May the benchmark Alerian MLP Index has handily outperformed, gaining roughly 10 percent in June. The Alerian MLP Index is one of the only industry indexes still trading higher this year.  

A year-to-date chart showing the relative performance of the MLP index vs. the S&P 500 is striking. Whereas the S&P has lost money so far this year, MLPs are up more than 15%!:

Source: Bloomberg

The reason is clear: energy MLPs are solid businesses with ample and dependable cash flows that grow over time. Many MLPs are pipeline companies that make most of their money as “tollkeepers” regardless of energy prices. Others have more exposure to energy prices through their natural gas liquids (NGLs) operations. With Elliott Gue forecasting $100 per barrel oil prices, both types of energy MLPs should continue to do extremely well in the months and years to come.

Leveraged MLP Exposure is Too Much of a Good Thing

Despite the wonderful investment opportunity MLPs provide, not all MLP investments are good ideas. Leave it to Wall Street investment banks to exploit excitement over MLPs for their own financial gain at the expense of the average investor.

On July 7^th, UBS (NYSE: UBS) issued the first-ever leveraged MLP exchange-traded note (ETN). It’s called the UBS E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index  (NYSE: MLPL) and is designed to provide twice the monthly return and twice the cash distribution yield of the underlying index. With the index currently yielding 6.87%, the ETN’s leveraged yield is 12.89%. 

Three Reasons to Avoid This Leveraged ETN

Sounds great, but the risks of investing in this ETN are huge and probably not worth your investment dollars. First off, ETNs are debt obligations of the issuer (in this case, a 30- year maturity) that promise to pay a return equal to that of the underlying index (minus administrative fees). Consequently, ETN investors are exposed to the risk that the issuer will default on its promise, compared to ETF investors who actually own the underlying MLP assets.

Second, cash distributions made by ETNs are considered taxable debt payments and classified as ordinary income; they don’t enjoy the tax-deferred treatment afforded to the cash distributions made by MLPs themselves and some MLP ETFs. As you may recall, 80% to 90% of a MLP’s cash distributions are typically considered a “return of capital” and consequently are not taxed upon receipt by the investors. Rather, the distributions reduce the investor’s cost basis in the underlying units and are taxed only upon the sale of the units (provided the cost basis is above zero). A 12.89% leveraged yield taxed at 39% has an after-tax yield of only 7.86% which, while still higher than the unleveraged 6.87% yield, does not adequately compensate an investor for the added risks of a leveraged ETN product.

Third, the performance history of leveraged ETFs has been miserable. One of the main reasons is that these funds achieve leverage by trading derivatives such as futures to hedge their positions and rebalance. These derivative trades incur substantial transaction costs that significantly erode these funds’ returns. Ben Shepherd, editor of Global ETF Profits, is “not a fan” of leveraged funds. He recently wrote about a ProShares leveraged short fund that lost a lot of money even though the underlying index moved in the downward direction investors in the fund were hoping for:

According to a class action lawsuit filed in a New York federal court, during the period from Jan. 2, 2008, to Dec. 17, 2008, when the Dow Real Estate index declined 39 percent, ProShares UltraShort Real Estate Fund lost 48 percent. According to the scheme, it should have appreciated about 78 percent.

To be fair, one of the advantages of ETNs over ETFs is that ETNs suffer less tracking error. ETN issuers promise to provide the return of the index (less administrative charges) and can’t use actual transaction costs as an excuse. However, the administrative charges that this ETN levies are significant and can cause the ETN to exhibit significant tracking error if the underlying MLP index moves in an erratic “up and down” fashion.

Take a look at pp. S-16 to S-19 of the prospectus. If the MLP index goes up every month by a constant 1.25% (Example 1), the ETN performs as expected, returning twice the index return of 16%. However, if the index goes up for six months and then down for six months (Examples 3 & 4), the MLP index is basically flat (-0.09%) but the ETN loses 1.80%, 20 times as much! As I wrote in The Great Investment Truth, this negative result occurs because of the asymmetrical wealth effects of gains and losses, with losses having a greater effect.

High Administrative Fees

The annual management fee (a.k.a. the “Annual Tracking Fee”) is a hefty 0.85%. But what worries me even more is the Accrued Financing Charge. This charge is based on 3-month U.S. dollar LIBOR (London Interbank Offered Rate), which currently is 0.526% and is an annualized figure. It seeks to represent the “amount of interest that leveraged investors might incur if they sought to borrow funds” needed to purchase twice the amount of MLP securities.  Right now, LIBOR is low but that could change quickly if inflation rears its ugly head. With no end in sight to the U.S. government’s trillion-plus budget deficits, a debasement of the U.S. dollar is virtually a certainty. As I wrote in Best Asset Classes for Stagflation, hedge fund legend Julian Robertson is making a big bet on inflation. At some point, LIBOR is going to rise significantly which will have a severe detrimental effect on this ETN’s net returns. 

Redeeming Your Investment At the Worst Possible Moment

Another thing I don’t like is the contractual provision (p. S-24) which calls for an automatic redemption of the ETNs if “the intraday index value on any Index Business Day decreases 30% from the most recent Monthly Initial Closing Level.” I’m pretty sure that this provision could have been triggered back in May during the May 6^th “flash crash.”  I don’t want to be sold out of a position at the worst possible time. As a patient investor, I want to be able to ride out temporary declines and ride my investments back up.

The call option UBS has giving it the right to redeem the ETNs anytime and for any reason after July 11, 2011 (p. S-6) also is irritating. Rest assured, UBS would only exercise this call option if it is in the bank’s best interest, which means it’s in the investor’s worst interest.

Leverage = Lower Yields?

Interestingly, the prospectus says (p. S-12) that the ETN is only suitable for investors who are “willing to receive a lower amount of distributions than you would if you owned interests in the Index constituents directly.” Why should any investor be willing to receive a lower distribution? The whole point of this product is to pay a higher distribution!

It just goes to show you that there is a real possibility that the administrative fees and asymmetrical returns associated with this leveraged product could eat away at your returns and turn MLP investing into a nightmare. Basically, leverage means that everything needs to go right for you to make money. And, as we all know, almost nothing in life goes exactly as you plan.

Conflict of Interest

Lastly, I don’t like the “Security Calculation Agent.” This person has “sole discretion” (p. S-57) as to the amount of the cash distribution investors receive, the amount of administrative charges deducted from cash distributions, the value investors receive if the ETNs are redeemed, the dates of payment, and virtually all things in between. I wouldn’t necessarily have a problem with this if the agent was an honest broker, but it’s anything but. In fact, the prospectus expressly states (p. S-30) that the Security Calculation Agent may have a “conflict of interest” with investors because it represents the interests of UBS! No thanks.

MLP Profits is the Better Bet

Everybody likes high yields, but the high fees, loss of tax advantages, dangerous leverage, and potential conflicts of interest inherent in the UBS leveraged product make it a non-starter for me. A much better alternative is to buy MLP units directly from the companies themselves. No fees, no leverage, no conflicts of interest. Dividend expert Roger Conrad and energy expert Elliott Gue, co-editors of MLP Profits, rate every single MLP that exists and have sell ratings on almost a third of them. To merit a buy rating from Roger and Elliott, a MLP must get passing grades from a number of criteria:

When we research a particular MLP, we look at distribution track record, management’s strategy and effectiveness, age of assets, percentage of capital spending devoted to growth as opposed to maintenance and the location of the assets themselves. The result is a comprehensive assessment of potential risk and reward.

Managing your own portfolio of individual MLPs with the guidance of MLP Profits allows you to concentrate only on the very best MLPs and maximize your potential gains. And who said you need dangerous leverage to achieve high yields? Roger and Elliott have found some MLPs they like that pay over 10%!

Try MLP Profits risk-free for the next three months. If it’s not for you, you’ll receive a 100% refund, no questions asked.