MLPs are the greatest thing since sliced bread, and if they haven’t cured cancer yet that’s only because they haven’t tried.  We’re not quite there in terms of top-ticking sentiment just yet, but it’s not been for lack of trying.

In a what-have-you-done-for-me-lately investing environment dominated by short-term thinking, the strong recent performance of MLPs has marked them as winners for the momentum crowd. The Alerian MLP Index is up 17.9 percent year-to-date in price and more than 20 percent on a total-return basis.

Total returns on MLPs have outstripped total returns on S&P 500 stocks by seven percentage points year-to-date, and more than 50 percent on a relative basis.

In another sign of worrisome complacency, the price of the JPMorgan Alerian MLP Index ETN (NYSE: AMJ) has run ahead of its net asset value by 3. 4 percentage points, boosted by inflows after JPMorgan stopped issuing new shares last June.  The AMJ was up nearly 2 percent in April, keeping pace with stocks, while the index it tracks has merely marked time.

Last week’s peak in sentiment coincided with lots of free publicity for MLPs as four senators introduced the Master Limited Partnerships Parity Act, which would extend tax-advantages of MLPs to renewable energy investments as well as energy efficiency projects, biochemical facilities, waste incinerators and, perhaps most appealingly to investors, landfills.

But we hardly need to wait for Congress to act to know that greed has triumphed over fear when it comes to MLPs. Forbes informs us that they’re starring in Hollywood, with a “cult following” among the film industry’s top money managers. “Buy MLPs” is the top suggestion in that article, titled “7 Secrets Wealthy People Know About Amassing And Maintaining A Fortune.”

Secret No. 8: Be extremely wary of stories like these and the investments they hype.

Last week’s gains also coincided with April’s ex-dividend dates ahead of May’s quarterly distributions, and the price momentum largely dissipated once these passed.

Come What May

Recent history gives more reasons for caution. Last year, MLPs lost 8.3 percent in May; in May 2011 they fell 5.7 percent and May 2010 cost them 6.2 percent.  The chase for yield, which transcends MLPs, may limit profit-taking in the near term.  But the seasonals do present another risk and another short-term obstacle.

None of this should diminish the long-term appeal of an asset class that still offers a richer yield than fixed-income securities with comparable risk, and one much better insulated against inflation. Alerian MLP Index constituents still yield 5.7 percent on an annual basis in aggregate, versus 3.4 percent from real estate investment trusts and 6.6 percent from the much riskier junk bonds. On a comparative basis, at least, MLPs remain a value proposition. And if distributions increase this year 6 percent to 8 percent as analysts expect, they will certainly justify double-digit capital gains.

At some point this will end in tears, as all bull markets do. But we’re not likely to get there until an economic boom still beyond the horizon spurs a significant rise in interest rates and creates a whole new set of capital misallocations, manifested among MLPs in aggressive issuance of new shares and speculative investments. We’re overdue for one of these after five years of recession and subpar recovery. But until it actually shows up, inflation and interest rates are likely to remain subdued, an environment tailor-made for the more conservative and diversified MLPs.

That’s my strategy for what should prove the second half of this bull market: to seek a combination of scale, geographic diversification and distribution growth that will permit us to participate in the upside based on MLPs’ relative advantages, while minimizing the inevitable damage when rates and expected returns revert back to historical norms.

This will mean not blindly chasing current yield but focusing on the fundamentals that will drive future distributions, including distributions coverage and the quality of management.  And it may entail sacrificing some performance in the near term for the sake of long-term security. But we want to do well over the long haul and over the market’s inevitable cycles. And that will mean investing selectively and opportunistically. Patient buyers should be able to do better than the current prices before the year is out.

In This Issue

First-quarter reports have begun to roll and several sector-heavyweights have seen shares retreat from 52-week highs in their wake despite announcing increases in distributions. See Portfolio Update.

The tax advantages of MLPs are greatest to those who plan to die holding them. If your investing horizon is shorter, present means modest or future income expectations high, consider an attractive alternative. See In Focus.

Two upstream MLPs have been the sector’s star performers since their public debut, yet continue to offer attractive distributions and strong growth potential. See Best Buys.