Exchange Traded Notes: High Yields -- and Risk

Investment advisors have been pouring billions of dollars into master limited partnership funds in recent years, grabbing on to these high-yielding securities as godsends for increasingly desperate, income-hungry clients. But many MLP funds are nothing like the mutual funds or exchange traded funds that retirees and other conservative investors traditionally buy. In fact, buying shares in the most popular MLP fund means giving an underwriter an unsecured loan; not taking an ownership stake in a portfolio of MLPs.

Do investors, advisors or otherwise, understand what they are buying in these products? Or are they just blindly grasping for yield here?

The attraction of MLP funds is obvious to anyone who has shopped for income-paying investments lately. MLP yields are much higher than those of blue chip stocks or Treasury bonds. A sample of a few income investments in the chart below illustrates the point. Yields from popular MLPs National Resource Partners (NRP), Enterprise Product Partners (EPD), and Energy Transfer Partners (ETP) range from about 4% to about 10%. Coca-Cola (KO) and Microsoft (MSFT), like most blue chip stocks now, have a dividend yield of less than 3%. 10-Year Treasury Bonds offer a pittance at about 1.8%.

NRP Dividend Yield Chart

NRP Dividend Yield data by YCharts

High yields on MLPs come from their unusual tax structure, which exempts them from corporate taxes but requires them to regularly give partners (shareholders) the vast majority of their cash flows. Investors gravitate to the funds, instead of individual MLPs, in part to avoid the necessity of collecting K-1s every year. (Funds generate the standard 1099s.)

The three biggest MLP funds carry just under 40% of the investment in these products, and they’re structured in a variety of ways. There’s the JPMorgan Alerian MLP Index ETN (AMJ), the ALPS Alerian MLP ETF (AMLP), the Kayne Anderson MLP Common (KYN), a closed-end fund. But the ETN structure is particularly popular with MLP funds. With ETNs, investors lending the underwriters money in exchange for a return tied to a certain index. ETN investors pay for the privilege with fees that are significantly higher than average ETF.

The biggest risk for ETN investors is that the underwriter gets into financial trouble and leaves them with nothing, like Lehman Brothers did with some of its ETN clients. But investors have lost money in less dramatic ways, as in the case last year, when Credit Suisse’s VelocityShares Daily 2x VIX ST ETN (TVIX) started trading wildly away from the index it tracks. Credit Suisse is still embroiled in fight with regulators and investors over that.

ETNs are not normally touted for traditional investment portfolios. They have complex fee structures, there’s no requirement for a board to protect shareholder interests, their values are difficult to peg, and they are not subject to the same disclosure rules as mutual funds or ETFs. Morningstar has called ETNs “one of the easiest ways individual investors and advisors unwittingly enter into adversarial relationships with vastly more sophisticated investment banks.” The Financial Industry Regulatory Authority (FINRA) issued an investor alert last year pointing out the risks of ETNs, including that the underwriter can redeem the securities at will, as well as make investment decisions at odds with interests of the funds’ investors.

But the demand for yield has made investors and investment advisors more open to ETNs. As Morningstar notes, the ETN structure makes more sense with MLP assets because these debt securities get certain tax advantages that MLP mutual funds and ETFs don’t. Performance is, of course, affected by more than just how much tax is paid. But the stock chart below gives you a sense of why MLP investors are enamored of the ETN structure. The Alerian MLP Index ETN made about twice as much money for investors since mid-2010 as the ALPS Alerian MLP ETF.

AMJ Total Return Price Chart

AMJ Total Return Price data by YCharts

Overall, the amount invested in ETNs has more than tripled in the past five years to $17.4 billion, according to the Wall Street Journal. That growth was helped immensely by the fervor for MLP funds and the creation of at least 40 new MLP products since 2010.

Generally, investors have made a lot of money in MLP funds in recent years, in a variety of structures. But they carry unusual, if not always outsized, risks that may surprise even their shareholders. So take a look at the fine print of that MLP product. Chances are, it’s not your father’s mutual fund.

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com.

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