With interest rates continuing to hover in the basement, investors looking for income have had to scour all sorts of asset classes in order to get their yield fix. From real estate investment trusts (REITs) to convertible bonds, nothing seems to be off-limits in the quest for yield. One of the biggest beneficiaries of investor’s newfound hunt for income has been master limited partnerships (MLPs)
The key is that due to their tax structure MLPs are required to pay most of their cash flows back to investors in the form of juicy distributions. Just how juicy? Try the 5% to 9% range on average. That fact has made them a great place to find relatively stable and steady income in the current environment.
But even investors who aren’t looking for income may want to consider MLPs. They are total return machines.
Total returns for MLPs have pretty much destroyed almost every asset class — from stocks to bonds — over the last 10 years. For investors, adding a dose of MLPs could be one of the biggest wealth creators for their long-term portfolios.
MLPs’ Primetime Performance
Back in the 1980s — in an effort to boost dwindling energy infrastructure investment — congress tweaked the tax code so that firms engaged in the “exploration & production, development, mining, refining, transportation or the marketing of any mineral or natural resource” could set up an MLP and pay no corporate tax on the assets in the vehicle.
Designed as “pass-through entities” — similar to REITs — MLPs by definition are required to pay large distributions to their unit holders. The general partner (GP) or sponsoring firm of the MLP, receives tax benefits by “dropping down” assets and dividends via the units it owns and incentive distribution rights (IDRs) from the MLP.
For an income point of view, the tax-structure is amazing. But from a total return point of view, it’s even more amazing
That’s because the majority of MLP cash flows are based on the volume of oil or gas that flows through their pipes — independent of the value of that liquid. With more and more energy activity happening in the U.S., demand for MLPs pipelines, gathering and processing facilities has exploded. That demand has pushed up cash flows on average. Since 2001, distribution growth for MLPs has averaged 7.8%. That’s about 3.4 times greater than rates of inflation and rising interest rates.
And over time, investors have continued to flock towards MLPs for those steadily rising cash flows.
Over the last 10 years — the sector benchmark Alerian MLP Index has managed to rise 149.9% on a price basis. Adding in dividends to that equation, and the Alerian surged forward nearly 365% higher. That works out to be an annual average return of around 15% per year. The venerable S&P 500 only managed to clock in with 2.1% return in that time. Even REITs — MLPs most likely competitor — only managed to produce an 8.2% annual total return during the last 10 years.
Adding Some MLP Muscle
And with America’s energy renaissance still in the third inning or so, total returns for MLPs should keep cooking for quite a while. That means investors not looking for income should consider adding the asset class to a portfolio.
The easiest way could be through the $8 billion ALPS Alerian MLP ETF (AMLP). The exchange-traded fund tracks the aforementioned Alerian index. This includes exposure to top MLPs like Kinder Morgan Energy Partners (KMP) and Enterprise Products Partners (EPD).
However, getting the exact return of the AMZ with AMLP is bit tricky. The problem is that due to regulation, mutual funds and ETFs are only allowed to hold 25% of their portfolios in MLPs. That means AMLP is actually structured as a corporation. And because of that, AMLP must pay corporate taxes on its holdings. It also causes AMLP to underperform its index by a decent margin and leads to an expense ratio of about 4.75% — or $475 per $10,000 invested.
Nonetheless, AMLP has managed to put up a nearly 50% total return since its inception since the summer of 2010. The other popular choice — the JPMorgan Alerian MLP Index ETN (AMJ) — isn’t great, either. Because it can no longer create shares, AMJ currently trades at premium to what the actual shares are worth. Investors are essentially paying more for less.
Another choice — one that’s pretty much ignored by investors — is the exchange-traded note UBS E-TRACS Alerian MLP Index ETN (AMU). As an ETN, AMU doesn’t feature the tracking error that AMLP has, but gives exposure to the benchmark MLP’s index. As such, it has pretty much tracked the AMZ — minus its 0.8% expense ratio — quite well. However, AMU isn’t perfect, either. ETN investors are subject to the credit risk of the underlying issuer. In this case investment bank UBS (UBS).
The bottom line: Even if you’re not a dividend hunter, MLPs belong in your portfolio. As a total return element, they simply can’t be beat. Over the last decade, they’ve managed to crush almost every asset class. And with energy resurgence still going strong in the U.S. that total return should keep on coming.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.