Chase Yield with MLPs and Short Commodities ETFs

At the moment, I’m sitting on some cash and don’t quite know what I should do with it. I’ve already got all the equities I can stand, some (but not many) bonds, some REITs. I don’t want to allocate into hedge funds or stuff like that, mainly because I abhor their ridiculous fee structures. But I sure don’t like the basically non-existent yield I’m getting on my money market accounts either.

What I am thinking I might do is to whip together a quick little absolute return strategy that will produce some tax advantaged yield while I figure out what to do next. So, the first thing I might do is to buy shares of Tortoise Energy – ticker symbol TYG. This is a corporation that invests in master limited partnerships: oil pipelines, stuff like that. Most master limited partnerships just split off considerable amounts of cash dividends, and the tax advantage is that the limited partners treat the first distributions as a return of capital (which is tax free) and after basis is recovered, the balance of distributions going forward are treated as capital gains. TYG currently yields about 9%.

There are three big problems with master limited partnerships. First, they tend to operate in multiple states. This means that the limited partners face tax filing requirements in multiple states, which is a huge administrative burden for most small investors. TYG, however, is a passive C corporation that invests in master limited partnerships, and does not distribute K-1s to its shareholders. This structure solves the multi-jurisdictional filing issue.

The second problem is that there is pretty low liquidity with master limited partnerships. They do trade publicly, but on thin volume. I don’t see any solution to that problem, so I guess if I implement my strategy, I have to live with this.

The third problem is that the price of many of these partnerships closely correlates to the underlying commodities. If you run a chart of TYY against an oil ETF such as iPath S&P GSCI Crude Oil Total Return Index ETN (ticker symbol OIL), you can’t help but notice that over the short term, the two things nearly move in tandem. But what I could do would be to also purchase an ultra-short oil ETF – such as ProShares Ultrashort DJ AIG Crude Oil ETF (ticker symbol SCO).

For illustration’s sake, I might take half of my cash and buy TYG, and the remaining half and buy SCO. My portfolio will be fairly risk neutral – yesterday, TYG was down about 3%, SCO was up 3%. In this example, my portfolio ought to yield about 4.5%, and on a very tax advantaged basis. Sure beats the paltry rate I get with my municipal bond money markets. And none of that annoying alternative minimum tax stuff to worry about, either.

Don’t get me wrong, this strategy (if I do it) is not risk-free. There is always idiosyncratic risk pertaining just to TYG – which holds diverse master limited partnerships, but still, it’s just one company. I have some basis risk concerns on my hedge, and I’ll be owning a stock that trades on relatively low volume. Due to these risks, the strategy is no substitute for a money market account, but a 4.5% premium over the risk-free rate seems very adequate compensation for my assumption of these risks, should I decide to implement the strategy.

Comments

[La Marque:]

TYG is an excellent choice for the small retail investor. FMO is a better choice IMO.

Jun 04 12:00 PM

[tc1:]

Here's a list from Hard Assets Investor on March 11, 2009 of various ways to get broader and easier exposure to investing in MLPs:

"Investors can access MLPs in many ways. Those looking for broad exposure can check out the Alerian BearLinx MLP Select Index ETN (NYSE: BSR), which tracks the Alerian MLP Index, or play a number of closed-end funds investing solely in MLPs, such as:

Kayne Anderson MLP Investment Company (NYSE: KYN) Tortoise Energy Infrastructure Corporation (NYSE: TYG)
Tortoise Energy Capital Corporation (NYSE: TYY)
Fiduciary/Claymore MLP Opportunity Fund (NYSE: FMO)
Energy Income and Growth Fund (NYSE: FEN)

Jun 04 01:07 PM

[Universal H...:]

A more comprehensive list of available MLP funds:

As far as I know, the Bear Stearns Alerian MLP Select ETN (BSR) is the only fund tracking the Alerian MLP Index (AMZS), however, BSR is a debt instrument and not an equity instrument and therefore subject to both market risk and issuer risk. In these troubled times, that makes many investors nervous about Exchange Traded Notes.

Kayne Anderson sports a small family of funds: KYN, KYE and KED. These are all Closed-End Funds. The Kayne Anderson MLP Investment Co. (KYN) is, as its name suggests, focused primarily on energy MLPs. It invests roughly 80% of its resources into midstream energy MLPs. The Kayne Anderson Energy Total Return Fund (KYE) is more broadly diversified in the energy sector. The last time I checked KYE was about 60% MLPs, and the rest in a mixed bag of production, development, transportation and storage. Kayne Anderson's third CEF is The Kayne Anderson Energy Development Co. (KED), which is about 60% invested in private energy companies and the rest in micro-cap MLPs.

The Tortoise CEFs closely parallel the Kayne Anderson funds: (TYG) Tortoise Energy Infrastructure Corp. consists of mostly midstream energy MLPs, (TYY) Tortoise Energy Capital Corp. includes MLPs and other select upstream and downstream energy companies involved in development, production, transportation and storage, and (TTO) Tortoise Capital Resources Corp. which invests in mostly private and micro-cap energy infrastructure not readily available to the retail investor. Both Kayne Anderson and Tortoise boast a number of experts and insiders from the energy MLP sector, and the impression I get is that both companies know their business and utilize industry contacts to make effective investment decisions.

There are also a few other CEFs you might want to consider: (FEN) First Trust Advisors Energy Income and Growth Fund, 5.36% expenses, all top-ten holdings are midstream gas & oil MLPs. (FMO) Fiduciary/Claymore MLP Opportunity Fund, about 80% MLPs mostly from midstream energy. And (MTP) MLP & Strategic Equity Fund, 1.3% expenses.

Looking at any of these nine funds is an easy way to invest while automatically diversifying and simultaneously avoiding the K-1 and UBTI tax issues.

Jun 07 11:14 AM