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.
MLPs in Your Portfolio
Now that you’ve read about the business models, risks, and fundamentals for MLPs, perhaps you have decided that an investment in MLPs is right for you and your portfolio. Now what? The first thing to do is decide how much of your portfolio to allocate to MLPs. Many investors use MLPs in their equity income sleeve, their real asset sleeve, or their energy or equity growth sleeve. In Alerian’s conversations with investors over the years, we’ve seen a typical allocation of 3%-6%; although depending on the portfolio’s objective, we’ve also seen upwards of 10%. It’s important to keep in mind that investments in MLPs come with risks, as do all equity investments.
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 diversified 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 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 features associated with distributions. 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.
For investors willing to do the work of researching individual securities and comfortable with single security risk, direct investment in individual MLPs may be an attractive option. Of course, once investors have decided to buy individual securities, there is the question of which one(s) to buy. As an indexing and market intelligence firm, our desire is to equip investors to make informed decisions about energy infrastructure and MLPs. To maintain objectivity, we do not make stock picks, and Alerian employees do not own individual MLPs or energy infrastructure corporations. However, after years of following the space, we have these recommendations for investors looking to put together a portfolio containing 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 do what they say they will do and have a deep bench of talent.
- Asset Footprint – Like Warren Buffett’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, companies which own a variety of assets along the energy value chain can clip multiple coupons along the way while also realizing cost savings from integration. MLPs with basin diversity have a natural hedge against changing hydrocarbon flows.
- Capital Markets Access – MLPs need access to capital to build or acquire assets. 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. Likewise, companies with an investment-grade credit rating or access to alternative sources of capital (such as a GP sponsor, DRIP, or PIPEs), will also have more capital flexibility.
- 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 growth.
- Financial Metrics – Low leverage ratios and low payout ratios (or high distribution coverage ratios) mean greater margins of error in terms of execution risk and during 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 needle for the company’s bottom line.
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.
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 exchange-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 are 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 to offset some of the effect of taxes. While leverage can increase returns when performance is positive, leverage will also magnify losses when performance is negative. 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, where 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 21% 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 $107.9. 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|
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 NAV, while ETF prices are determined by the market. ETFs may also be sold short. Typically, MLP ETFs have lower fees, ranging from around 50 basis points (bps) to 100 bps. Mutual funds fees in this category are a bit higher and range from around 70-140 bps. 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% 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 midstream C-Corporations, utility companies, exploration and production companies, refiners, MLP ETNs, 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%
Investors that prefer broad exposure
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
100% MLP exposure
|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
Active Versus Passive
Although this will vary by investor, the next thing to decide in regards to an MLP investment philosophy is active versus passive management. While this decision is germane to any sector, there are a few things unique to the midstream space. Advocates of passive investing note that over the long term and after factoring in fees, active managers are unable to consistently outperform the index to which they benchmark their performance. Advocates of active investing argue that with extensive research on individual companies, selective investing, and close monitoring of securities, a portfolio manager can generate alpha, or risk-adjusted outperformance versus a benchmark.
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 securities, but still would like active management, Alerian recommends considering the following factors when selecting an active manager.
- History – As stated previously, past performance is not an indication of future returns. However, the MLP space is still relatively young. MLP market capitalization has increased remarkably since the mid-2000s. As one can imagine, with the outsized growth of the space leading up to 2014, many money managers entered the midstream space. It is worth looking into the track record of an active manager being considered.
- Outperformance – The entire purpose of paying for active management is to outperform the benchmark index after fees. If the active manager is not consistently outperforming the index or is underperforming the index after fees, an investor is better served by investing in a passively managed product. Outperformance in a single year may be notable 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.
Choosing an Indexed Product
As an indexing firm, Alerian constructs and maintains energy infrastructure and MLP 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 energy infrastructure and MLP 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 like active management than a true 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 and others may be focused on income.
- Objectivity – An index provider may be tempted to include certain 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 helps maintain objectivity. Additionally, indexing firms should be careful to avoid conflicts of interest with actively managed investments.