Most people invest in an S&P 500 fund because they want broad exposure to the US stock market. Afterall, the S&P 500 is billed as including “500 leading companies and captures approximately 80% coverage of available market capitalization”. Which means it includes companies as large as Apple Inc (AAPL) with a market cap of over $750 billion, down to companies like Chesapeake Energy Corporation (CHK) and Transocean Ltd (RIG) with market caps of $4 billion and $3 billion respectively. That’s a lot of companies, but here’s the important point: it’s incomplete.
The S&P 500 methodology specifically excludes MLPs. Using S&P’s $6.1 billion limit, there are 17 MLPs that would be part of the index, absent that restriction. Said another way, without the arbitrary exclusion, the majority of the companies in the Alerian Large Cap MLP Index (AMLI) would be included.
A brief example of the kinds of companies excluded is below.
Why are MLPs excluded?
No official reason is given. MLPs are simply included in the list of excluded companies, which also includes business development companies (BDCs), limited liability companies (LLCs), and ETFs. As a matter of pure speculation, it could be because the partnership structure necessitates a Schedule K-1 and attendant state tax filings, which creates tax headaches for the back offices of funds. Alternatively, it is possible that since MLPs are relatively new, they are unknown and untrusted entities to fund managers. (Then again, ETFs themselves are rather new.)
There is no way to know for certain.
What Does the Exclusion Mean?
If the S&P 500 does not include MLPs, neither will funds designed to track it. While the SPDR S&P 500 ETF Trust (SPY) is a very popular way to gain exposure to the broad US market without paying 500 separate transaction fees, it is by far not the only way to do so.
The Fortune 500 list is designed to capture the top 500 companies by total revenue. Its methodology does not exclude MLPs, and indeed, in 2017, MLPs like Enterprise Products Partners (EPD), Plains GP Holdings (PAGP), NGL Energy Partners (NGL) made the list. (All three, for reference, were in the top half.) However, the new Barclays index based on that list will exclude MLPs, just like S&P does.
The Vanguard Total Stock Market ETF (VTI) is perhaps the best known of the total stock market ETFs. It originally tracked the Wilshire 5000 Index (now tracks the CRSP Total Market Index), and has gathered $575 billion in assets. There are 3,572 holdings in the index, and not one of them is an MLP.
It’s arguable that investors who use these products thinking they have the broadest exposure, in fact, lack exposure to MLPs. While the decision to invest (or not) in a particular asset class always belongs to individual investors, those investors who chose a broad product thinking they have exposure to every asset class are mistaken.
What Can I Do?
Accept indirect exposure.
Many companies in the S&P 500 are general partners of MLPs, which means investors would get a small amount of exposure to MLPs through them. Examples include: Phillips 66 (PSX), GP of Phillips 66 Partners (PSXP); Tesoro Corporation (TSO), the GP of Tesoro Logistics (TLLP); and EQT Corporation (EQT), GP of EQT Midstream Partners (EQM). It’s not perfect exposure, but it’s better than nothing.
A handful of energy companies in the S&P 500 operate midstream assets, and for some, it is even their primary business. The most famous example of this is Kinder Morgan Inc (KMI), which famously merged with its daughter MLPs a few years ago to become one S&P 500-eligible company. Since midstream MLPs are what most investors have in mind when they look for an MLP investment, this is potentially also acceptable, albeit incremental exposure.
Of course, if you want MLP exposure, the simplest way to get it is to invest in MLPs. Alerian’s website details the numerous ways to gain exposure to the asset class. All the same, I would also be remiss not to reiterate that for a US taxable investor comfortable with filing K-1s and state taxes and building a diversified portfolio, he or she will always be better off buying MLPs individually.
Currently, the energy sector is 6% of the S&P 500. Utilities are around 3%. Since energy infrastructure fits somewhere in between those two, moving 4%-5% of money allocated to the S&P 500 to an MLP fund could add exposure while maintaining a diversified sector balance.
Another way to consider an allocation would be that since the 20 largest MLPs have a market cap of around $300 billion, that would approximate 1%-2% of the over $20 trillion of market cap captured by the S&P 500. So, a 1%-2% allocation could also be a reasonable amount, judged on a pure market cap basis. Like everything else with investing, investors must make their own decisions.