The incredible breadth of MLP investment product selection is due to the wide variety of aspirations and risk tolerances investors have for their MLP allocation. This section is intended to help investors distinguish between and sort through the various investment products.
If you’ve reached this point in the MLP University, you may have already decided that MLPs are an investment you’re interested in pursuing. The case for MLPs in most portfolios runs something like this: a base 6% yield, plus conservative distribution growth of 3%-5% produces a 9%-11% total return. Many investors are looking for yield these days, or exposure to real assets, or for a way to invest in shale plays and America’s growing energy independence. As MLPs benefit from a largely benign regulatory environment, many investors are comfortable with the risks involved.
So, you’ve decided that MLPs are the investment for you. You’ve read about the business models, you’ve gotten comfortable with the risks, and you think they could be a good addition to your portfolio. Congratulations!
The first thing to do is decide how much of your portfolio to allocate to MLPs. Some investors do have outsized MLP allocations and have done very well over the past decade; however, MLPs are equities, and they are at-risk investments. Many investors use MLPs in their income sleeve, their real asset sleeve, or their equity sleeve. For additional color, Energy and Utilities, which are before and after midstream MLPs on the energy value chain, comprise 8.3% and 3.4%, respectively, of the S&P 500’s index weight.
Buying Individual MLPs
One of the lines that we repeat over and over is, “For a US taxable investor that is comfortable filing K-1s and state taxes and building a portfolio, s/he will always be better off buying individual MLPs directly.” “Always” isn’t a word financial folks use very often. To break that down, we mean an investor who is taxed in the US and is investing in a taxable account (not an IRA, 401(k), or other tax-advantaged vehicle). Also, that investor is willing to receive and file K-1s (as opposed to 1099s) as well as filing any associated state taxes. Or, the investor is willing to pay an accountant to do so on her behalf. Also, the investor is willing to do the work of researching and choosing individual MLPs and taking on the associated risks with security selection and portfolio construction. If all of those constraints are not a problem, the most tax-efficient way to access the asset class (and incidentally, pay the lowest fees) is to buy MLPs directly.
MLPs can be more tax-efficient investments than many other stocks due to their pass-through structure. From an estate planning perspective, if units are passed along to heirs, upon death of the unitholder, the basis is “stepped up” to the fair market value of units on the date of transfer, thereby eliminating a taxable liability associated with the reduction of the original unitholder’s cost basis.
Of course, once investors have decided to buy individual MLPs, there is the question of which MLP(s) to buy. As an indexing and market intelligence firm, our desire is to equip investors to make informed decisions about MLPs and energy infrastructure. In order to maintain objectivity, we do not make stock picks, and Alerian employees hold no individual MLP positions. However, after years of following the space, we have these recommendations for investors looking to put together a portfolio of MLPs.
- Management Teams – Consider the management team of the MLP. Solid management teams are those that have led the company to build new projects on time and on budget, that have been effective and efficient stewards of investor capital, and who work well together and have excellent relationships with their customers, investors, and other industry stakeholders. They also admit when they are wrong and have a deep bench of talent.
- Asset Footprint – Similar to Warren Buffet’s moat, those MLPs which already own land and rights of way in growth areas benefit from their established position by being able to expand their position without excessive political or regulatory headwinds. Additionally, MLPs which own a diversity of assets along the energy value chain are able to clip multiple coupons along the way while also realizing cost savings. MLPs with basin diversity have a natural hedge against continually changing supply and demand flows.
- Capital Markets Access – MLPs need access to capital to build or acquire assets. In order for these expansion projects and acquisitions to generate a positive return, this capital must come at a cost below the expected return of the asset. MLPs with a bigger footprint, greater margin for error, and lower business risk tend to have better and cheaper access to capital.
- Sponsor – Most sponsors fall into one of three buckets: publicly traded energy or utility companies, private equity firms, and management. A sponsor can give an MLP access to a multi-year growth story through dropdowns and can also provide support if and when an MLP runs into difficulty. However, having a sponsor that owns IDRs can also raise the cost of equity for an MLP, making expansion projects and acquisitions less accretive.
- Growth Opportunities – Obviously, all investors would like to own companies that continue to expand their asset footprint. Organic growth projects tend to generate a higher internal rate of return (IRR) than acquisitions, so MLPs with a larger backlog of projects relative to their current size are likely to have more visibility to distribution growth.
- Financial Metrics – MLPs with low leverage ratios or high coverage ratios have a bigger margin of error in terms of execution risk, as well as unforeseen macroeconomic issues (including severe weather and commodity price movements).
- Size – Larger MLPs can more easily access the capital markets and are more likely to get investment grade ratings, have higher trading liquidity, and reach a broader investor group. However, it also takes bigger projects, built or acquired, to move the distribution needle.
With some MLPs, investors have the option of buying the individual MLP or its general partner. GPs manage the partnership’s operations, receive IDRs, and generally maintain a 2% economic stake in the partnership. Through ownership of IDRs, several MLP founders, such as Rich Kinder and the late Dan Duncan, became billionaires. The current phase of GP offerings has seen sponsors such as TRGP and KMI elect the C corporation structure. Rather than receiving a potentially complicated Schedule K-1, C corporation investors receive a simple Form 1099. For investors interested in direct MLP ownership but unable or unwilling to receive a K-1, the C corporation GP can be an attractive option. When making a decision, investors are urged to consider the relative valuations of the GP and LP, the growth opportunities available to the LP and the implications for the IDRs, and the capital discipline and financial stewardship of the management team.
Active versus Passive
Although this will vary by investor, the next thing to decide is MLP investment philosophy in regards to active versus passive management. While this decision is germane to any sector, there are a few things unique to the MLP space. One argument in favor of active management is the dispersion of returns. Theoretically, an active manager will position a portfolio to hold large positions in those MLPs who will have large returns and to short or not hold those MLPs which will not do well. In practice of course, consistently outperforming a benchmark is difficult.
Individual MLP market capitalizations range from a couple hundred million dollars to tens of billions of dollars. If an active manager running a $1 billion portfolio would like to put on a 1% position in a small MLP, liquidity constraints may prevent the manager from being able to enter or exit the position in a reasonable amount of time. This may cause active managers to take large positions in the larger, more established MLPs, which are the same MLPs in a market-cap weighted index. This phenomenon is known as closet indexing.
Choosing an Active Manager
For those investors who are not comfortable choosing their own MLPs, but still would like active management, Alerian recommends considering the following factors when selecting an active manager.
- History – As stated ad nauseum, past performance is not an indication of future returns. However, the MLP space is still a very young space. MLP market capitalization have increased tenfold to more than $500 billion over the past 10 years. As one can imagine, with the outsized growth of the space, suddenly there are many money managers entering the MLP space. If a manager claims to have been actively investing in MLPs for the past ten years, it is worth looking into his or her track record, as very few people were actually investing in MLPs 10 years ago.
- Outperformance – The entire purpose of paying for active management is to outperform the index after fees. If the active manager is not consistently outperforming the index, or, after fees is underperforming the index, an investor is better served by investing in a passively managed product. Outperformance in a single year may be outstanding, but consider whether the manager has outperformed in previous years and under various market conditions.
- Differentiation – An active manager whose portfolio closely mimics an index may be engaging in closet indexing. Investors are encouraged to examine the underlying portfolio to be sure it matches the investment thesis and philosophy of the manager.
- Turnover – Frequent trading could trigger tax bills for the fund that may not be in the best interest of investors. Many investors are attracted to the MLP space for the tax benefits that holding MLPs can provide, such as a potentially large percentage of distributions being tax deferred. However, this tax deferral lasts only until the sale of the position, so a manager with a high turnover ratio may not be passing along this benefit to his or her clients.
Choosing an Indexed Product
As an indexing firm, Alerian constructs and maintains MLP and energy infrastructure indices which it licenses to its partners for the creation of passively managed investment products. We launched the first real-time MLP index in 2006, which has since become the industry standard benchmark, and we continue to work hard to maintain indices that meet the most rigorous standards. With that bias in mind, Alerian recommends that investors looking for a passive investment consider the following when researching underlying indices.
- Transparency – Passive investors should know what they are buying. The constituents of the underlying index should be available to investors, as should the methodology used to determine those constituents. If a change is to be made, that information should be public as well. Any index that lacks transparency is more similar to active management than to a truly passive investment. A transparent portfolio allows investors to be sure the underlying portfolio matches their investment thesis. Not all MLP indices are the same—some are midstream focused, others are focused on income, and still others exclude energy MLPs.
- Objectivity – An index provider may be tempted to include MLPs for subjective reasons: a personal investment, a relationship with the management team, or to juice returns on a stock already included in an actively managed fund. For each index, there should be rules in place to prevent personal opinions and emotions from impacting the construction and rebalancing of the index. Having a codified set of rules that is transparent and freely available to the public, as well as prohibiting index committee members from taking positions in individual MLPs in their personal accounts, all help maintain objectivity. Additionally, indexing firms should be careful to avoid conflicts of interest with actively managed investments.
The Myriad of MLP Investment Products
Many investors do not fit the criteria listed above for buying individual MLPs, but thankfully, a variety of MLP access products are available to investors.
As readers will remember from earlier sections of the MLP University, MLPs are pass-through structures that do not pay taxes at the entity level. Instead, income and deductions are passed through to the end investor. Regulated investment companies (RICs) such as Closed-End Funds (CEFs), Mutual Funds, and Exchanged Traded Funds (ETFs) under the Investment Company Act of 1940 (collectively, “40 Act Funds”) are also pass-through structures. Under current law, 40 Act Funds seeking to retain pass-through status are prohibited from owning more than 25% of their assets in MLPs. Funds that abide by this law have come to be called “RIC-compliant.”
There are funds that have more than 25% of their assets in MLPs; however, these funds are no longer pass-through structures and are required to pay taxes at the fund level. Functionally, this means that fund performance is reduced by the amount of taxes accrued (i.e. will be owed when positions are sold). Think of it like your employer withholding a certain portion of income taxes. In this case, the fund withholds (or accrues) a portion of the returns. Some funds will use leverage in order to offset some of the effect of taxes. While leverage can increase returns when performance is positive, when performance is negative leverage will also cause the fund to lose more money. These funds are also able to preserve the return of capital benefit for their investors, and since they can own 100% MLPs, the proportion of income that is classified as return of capital is greater. They tend to be favored by investors seeking to maximize after-tax income.
Some funds are passively managed, meaning the performance is linked to an index or benchmark. These funds tend to have lower fees. An actively managed fund has higher fees to account for the fact that a portfolio manager must be paid to choose individual stocks.
To help navigate the variety of investment products available, Alerian has provided the decision tree shown below.
40 Act Funds - C corporation taxation - 100% MLPs
A 40 Act Fund such as a mutual fund, CEF, or ETF which owns more than 25% MLPs will be taxed as a C corporation. As the underlying positions increase in value, the fund will accrue a deferred tax liability (DTL) to account for taxes that will be owed should the position be sold. This DTL is assessed at the corporate tax rate of 35% and assumed rate attributable to state taxes. The DTL is removed from the Net Asset Value (NAV) of the fund, meaning that if the value of the underlying portfolio rises from $100 to $110, the fund’s NAV will move from $100 to $106.5. As the position falls, the DTL will be reduced. When the fund is in a net DTL position, the DTL effectively reduces the volatility of the underlying portfolio, assuming no leverage is employed. If the fund has no DTL to unwind, it will track the underlying portfolio on a one-for-one basis. Fund distributions track the return of capital proportion of the underlying basket of securities and lower an investor’s cost basis.
|Advantages:||Owning the underlying securities
Tax character of distributions mirrors that of underlying portfolio
Fees are taken from the NAV, preserving the yield
|Disadvantages:||DTL mutes gains and losses when the fund is in a net DTL position|
|Suitability:||Taxable investors seeking after-tax yield
Investors who prefer low volatility
ETFs vs Mutual Funds
ETFs trade throughout the day; whereas mutual funds price only at the end of the day. However, mutual funds always price at Net Asset Value (NAV), while ETF prices are determined by the market. ETFs may also be sold short. Typically, MLP ETFs have lower fees, ranging from 45bps to 95bps. Mutual funds fees in this category range from 70bps to 135bps. Mutual funds may also use up to 33% leverage.
CEFs were the first 100% MLP C Corporation, 40 Act products. Like mutual funds, they can also use up to 33% debt leverage. Because CEFs do not have a creation/redemption feature, pricing may stray from NAV, causing them to trade at a premium or discount. Their liquidity is also constrained by the fund itself as opposed to the underlying securities held.
40 Act Funds – RIC Compliant – Less than 25% MLPs
Funds which own less than 25% MLPs do not pay taxes at the fund level, enabling them to pass through the entire return to their investors. The return of capital benefit from owning MLPs is muted due to the limit imposed on MLP ownership. Investors interested in RIC-compliant MLP funds should research what the fund owns for the other 75%. Common positions include utility companies, exploration and production companies, refiners, energy infrastructure companies, MLP ETNs, MLP GPs structured as C corporations, and cash.
|Advantages:||Ownership of the underlying securities
Little to no tracking error
|Disadvantages:||Maximum of 25% of portfolio invested in MLPs
Other 75% performance can meaningfully deviate from MLP performance
Generally lower yield
Total return investors in a taxable account
Investors without exposure to the asset classes in the other 75%
As with 40 Act Funds that make a C corporation tax election, RIC compliant 40 Act funds may be mutual funds, CEFs, or ETFs.
Exchange-Traded Notes (ETNs)
An ETN is an unsecured debt obligation of the issuer. It is an agreement between an investor and an issuing bank under which the bank agrees to pay the investor a return specified in the issuance documents. MLP ETNs may track a basket that is 100% MLPs without accruing for DTLs.
|Advantages:||Little to no tracking error as the bank agrees to pay the return
Intraday knowledge of portfolio holdings
Generally lower expense ratio than MLP 40 Act Funds
|Disadvantages:||Coupons are taxed at ordinary income rates
Lower income as the expense ratio is removed from coupon payments
Exposure to the credit risk of the underlying bank
|Suitability:||Tax-advantaged accounts such as 401(k)s or IRAs
Total return investors in a taxable account
Investors comfortable with the credit risk of the financial institution
Separately Managed Accounts (SMA)
An SMA is an account that is managed by a portfolio manager. Unlike owning a basket of individual MLPs and receiving multiple Schedule K-1s, an SMA consolidates everything so that the investor only receives one Schedule K-1. SMAs may generate UBTI. Once UBTI exceeds $1,000 in an account, additional taxes may be assessed.
|Advantages:||Preserves tax characteristic of the underlying investment
Typically lower fees than publicly traded products
|Disadvantages:||May generate UBTI
Issues a Schedule K-1
High minimum investment
|Suitability:||Large institutions such as pensions and endowments
Very wealthy individual investors