The Index Approach to Master Limited Partnerships

| About: Magellan Midstream (MMP)

Energy and natural resource master limited partnerships [MLPs] have yet to catch on among many investors, despite their numerous advantages, such as high yields, stable income and immunity to volatility in commodities prices. But Swank Capital, LLC is working to change all that; this Texas-based boutique investment manager has recently launched the Cushing 30 MLP Index, a new benchmark tracking North American infrastructure MLPs.

Daniel Spears, a partner at Swank Capital, is no stranger to MLPs. With 14 years' experience in investment management and investment banking within the natural resources sector, Spears is an expert in energy and infrastructure MLPs. He also currently serves as portfolio manager for the Swank MLP Convergence Fund, L.P.

Recently, HAI Associate Editor Lara Crigger chatted with Spears about MLPs, including how MLPs are like REITs, how investors can use MLPs to hedge inflation and what's behind the company's new Cushing 30 MLP Index.

Lara Crigger, associate editor, (Crigger): What advantages do MLPs offer investors over other types of commodity-based investments?

Daniel Spears, partner, Swank Capital (Spears): First of all, the majority of MLPs are not commodity-sensitive organizations. Most MLPs are created primarily to hold assets that have tremendous amounts of cash flow, such as pipelines, etc. It is a model similar to REITs: Just as REITs have to distribute all of their income to shareholders, and they're not taxed at that level, MLPs have to distribute all of their cash flow to investors and are not taxed at a corporate level.

Predominantly the midstream MLPs hold pipelines, processing plants, crude storage tanks or crude pipelines, or they hold refined products like gasoline or jet fuel, and those pipelines and those storage facilities. That means MLPs really are the middle of the road: On one end, you have the companies out there, poking holes in the ground, looking for oil and natural gas; and then on the other end, you have the consumers. MLPs are the "toll roads" in between.

Crigger: MLPs' agnosticism to commodities prices helped them weather the down market last year. What's the outlook for 2010?

Spears: Our view is that for 2010, we should see growth in distributions return. Last year, it was about 4 percent. The previous few years, it had been 9-12 percent. So I think in 2010, you're going to see distribution growth come back into the 4-6 percent range.

That said, a lot of companies are spending dollars today that will add substantially higher growth in 2011. And the companies that have amassed this distribution growth should outperform.

Crigger: MLPs are often touted as a way to hedge inflation, but are some MLPs better at this than others?

Spears: The way I look at using MLPs as an inflation hedge is to compare their underlying distribution growth with the CPI; that is, if you have a view on where CPI is going, then you should look into investing in an MLP whose distribution growth is higher than that.

You can also look at which companies have embedded CPI protection in them. A lot of those companies are on what we call the "products pipelines." Magellan [Midstream Partners, LP (NYSE: MMP)] is one example. They own a lot of pipelines that simply transport diesel and jet fuel - the end-crude product. Their pipelines are FERC [Federal Energy Regulatory Commission] regulated, and then there's a FERC-regulated adjustment based upon the finished goods PPI mix. Therefore, their tariff goes up by the PPI; it's just part of the formula. So there's the embedded feature of inflation production.

Crigger: MLPs offer a lot of advantages for investors, but they're still not well known as an asset class. Why do you think this is?

Spears: Because it's still very small. Now it's about half the size of the REITs, making it a $200 billion market cap sector.

Plus, it's still predominantly retail, probably about 70 percent retail. In 2004, there was a tax law change that allowed mutual funds to increase their percentage in MLPs from 10 percent to 25 percent. But few have gone into that. Most of what you have on the institutional side are dedicated money managers, like ourselves, and closed end funds; those are the primary institutional drivers of this asset class.

Also, I think there's a lot of tax confusion about MLPs for some investors, because of filing a K-1 form vs. filing 1099s. Some people, they hear K-1, and they get scared and run away; others don't have a problem with it.

Crigger: I wonder how much of it has to do with whether or not they do their own taxes.

Spears: Probably! What you have is a class of individual investors who love MLPs, and you have certain major institutions in them. Take Goldman Sachs; if you're in their private network, there's going to be a certain percentage of your portfolio that gets invested in MLPs.

Crigger: Let's switch gears and talk about your new index. A few other MLP indexes are out there, so what distinguishes yours from the rest?

Spears: All the other indices out there right now are market-cap weighted. But there are some deficiencies of a market cap weighting versus other ways to weight it.

Crigger: Sure. The big guys tend to dominate the portfolio, while the little guys get left out.

Spears: Right. One of the indexes out there is the Alerian [MLP Index]. It has its 50 stocks, and it's market cap weighted; just five stocks comprise about 50 percent of the index. From a portfolio management perspective, that's not how many people would think of diversification.

So our view was, we wanted to find an asset class or an index that represented the best attributes of the asset class as a whole. The next step was viewing "How do we weight it?" We felt that an equal-weighted index showed you a best cross section of all the best companies.

Crigger: What kind of criteria did you use to choose which MLPs make it into the index?

Spears: It's called SValuES, and it emphasizes the importance of balance sheet, cash flows, cash distributions, yield, growth, and so on, over something like market capitalization. In our view, we want this index to be an independent index that does the best job of someone being able to benchmark the asset class.

Crigger: Are any MLP sectors excluded from the index?

Spears: There are two subsectors that have a lot of commodity risk: upstream and shipping. And we exclude those from our index. When people think of MLPs, these aren't the sectors they should be thinking about; they should be thinking about the utilitylike distributions, and the toll-road aspect of these assets.inter