In theory, selling master limited partnerships these days should be as easy as selling bottled water before a hurricane. Most MLPs invest in energy infrastructure. Theres an energy renaissance going on in the United States, thanks to fracking. With an MLP, an investor is buying into all that oil and gas without the price volatility of oil and gas.
But to lay investors, a natural resource MLP can be confusing. Its not a bond, but it has quarterly disbursements. Its not an oil company tied to futures prices, but its trading can be volatile, and clients can easily lose money with the wrong picks. Theres also a tax benefit, since some of the income it provides can be treated as tax-free return of capital.
REITs are probably the closest comparable asset in terms of MLPs being a flow-through security, says Greg Reid, managing director of Salient Partners.
MLPs dividends come from the cash flow that the partnerships derive from lease and rental payments. As demand for those assets increases, the price that energy companies pay for those assets rises. If it costs more for a partnership to build a pipeline, then those costs are offset by higher charges to end users.
Rising yields mean falling bond prices. Rising yields do not necessarily mean falling MLP equity prices.
Thanks to a new product stream, MLPs are no longer just for high net worth individuals looking for tax relief. In fact, wealthy clients are more inclined to use MLPs as a growth and income investment than as a tax strategy.
Salient Partners runs $4.5 billion in MLP funds that it sells directly and through registered investment advisors. The reason many investors like MLPs is that you can potentially get a 5% or 5.5% yield, plus a growth rate on that dividend of potentially 20%, Reid says, giving a best case scenario.
But there are much worse cases. The performance differential between the best and the worst is around 250%.
The Alerian MLP Index, considered the benchmark gauge of the MLP sector, was up 6.7% year-to-date as of Nov. 6, while the S&P 500 had risen 9.8% and the spot price for West Texas crude was down 19.8%. But the Alerian index year-to-date performance had been more than double that level of return on Sept. 30. Then, oil prices declined quickly in October, and many investors pulled the plug on their MLP holdings. The index fell 12.8% in the first two weeks of the month.
Reids Salient Midstream & MLP closed-end fund (SMM) lost nearly 19% in the two-week period ended on Oct. 14, and Salients MLP and Energy Infrastructure II mutual fund shed 14.5%. Many mutual funds are taxed as C-Corps and some hold oil and gas stocks, hurting returns.
This is the fifth time we had a selloff of more than 10% in the Alerian MLP index, says Kyri Loupis, a portfolio manager and managing director of MLP strategies for Goldman Sachs Asset Management. Crude oil drove this drop. People cannot have the misperception that oil affects MLPs directly because it does not. What matters for these companies is volume of oil and not oil price.
Despite the swoon in early October, the Alerian index has shown very little correlation with oil over the last 12 months. In that period, the MLP index has risen 8.98% compared with oils 15.7% drop.
MLPs beat oil over time, but they are subject to oil price volatility in the short term and will face new risks as interest rates rise.
The Alerian MLP Index dates back to 1996, when interest rates were 5.3%. The index posted boring, but steady, gains even in a rising interest rate environment all the way to the year 2000. At that point, interest rates had risen to 6.24% and the index lost its four-year gains.
Oil prices were also on the wane, with WTI crude trading at $22.12 a barrel in 1996, and falling to $14.42 two years later. Alerian outperformed, but it wouldnt be long before it caught up with the decline in oil.
But long term the trend has been steadily upward. In the early days of trading, the index was around 104, and it stood at 133 at the turn of the century. The index hit a historic high of 1,896 on Aug. 29. Rising interest rates will probably slow this run as fixed-income investors will be more likely to lock in long-term rates.
THE CASE FOR MLPS
But rising rates wont change the long-term case for buying master limited partnerships. The asset provides high yield and has historically tacked on around 8% growth to that dividend each year. The growth comes as MLPs charge more for renting or leasing their equipment.
The thing you must remember about MLPs is that youre not just buying it just for the yield, Loupis says. Youre also buying it for the growth.
Investment firms are churning out new MLP products each year. In 2008, there were only 11 MLP funds on the market with a market capitalization of $4 billion. Today, there are 71 publicly available MLP products with a market cap of $80 billion.
Investors seeking tax benefits tend to open separate accounts and take on the extra administrative burden of the K-1 tax form rather than the simple 1099 theyd get from a mutual fund.
Investors receive a K-1 for each MLP in the account and pay a management fee, typically around 1 to 1.5%. The key benefits of this structure are the full flow-through of MLP tax benefits, daily liquidity, professional management, and fees and expenses typically lower than the other investment options.
The separately managed account passes through the unrelated business taxable income of MLPs, so tax-exempt investors should consult with their tax advisors before investing, says Curt Pabst, managing director of Eagle Global Advisors and co-advisor to the Eagle MLP Strategy Fund (EGLIX).
Eagle launched its mutual fund in 2012 with just $20 million of its own capital. It now has $897 million in assets.
Accredited investors can also go the route of commingled investment partnerships, which offers the benefits of a diversified MLP portfolio and professional management, plus a consolidated K-1. This structure provides for the full flow-through of the tax benefits of MLPs without the corporate level tax drag. Fees and expenses will vary, but are typically below the fees and expenses associated with closed-end funds, Pabst says.
Individual tax situations, liquidity concerns and the ability to meet investment minimums all play a role in deciding which MLP investment option works. Some individuals may not have enough capital to meet minimum investments in private partnerships or professionally managed separate accounts.
Within the MLP product space, the holy grail for individual investors has been in finding highly liquid MLP structures without all the headaches of K-1, yet in a way that doesnt alter their tax benefits.
This has been an unsolvable Rubiks cube for us, Pabst says about building EGLIX. Four years ago, most MLP mutual funds were all closed-end funds and they had to pay taxes at the fund level. Their returns were suffering. The closed-end MLP funds all lagged the index. As a portfolio manager, we didnt want to create an MLP structure that subjected itself to an additional tax. Once we felt we could stick to midstream energy and infrastructure through C corp listed equities, we launched this fund.
Pabsts fund is up 12% net of fees over the 12 months ended Nov. 6. It yields 5.63%.
THE SHALE REVOLUTION
Holding MLPs is like owning a part of the shale revolution. The Interstate Natural Gas Association of America has forecast that the U.S. needs $30 billion every year in new oil and gas infrastructure for the next decade. Three years ago, that forecast was $10 billion a year. Ten years before that, everyone was talking about peak oil.
If MLP sellers are correct, this asset will increasingly be seen as a growth story with tax and inflation benefits so long as oil prices dont undercut the drillers most MLPs are dependent on.
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