The next stop in my quest for high retirement income at a reasonable risk was to consider Master Limited Partnerships (MLPs). You can purchase MLPs as individual units (purchased like a stock from your broker) or via Exchange Traded Funds (ETFs), Exchange Traded Notes , or Closed End Funds (CEFs). There are already many articles on Seeking Alpha that discuss the merits on individual MLPs so I will focus on the risk versus reward associated with ETFs, ETNs, and CEFs.
But before I begin the analysis, I believe a quick tutorial is in order since there are some unique aspects of MLPs. This will be a high level overview since I am not qualified to cover all the tax related nuances of MLP investing.
MLPs have relatively complex rules stemming from the Revenue Act of 1987 which provided tax advantages to partnerships that earn at least 90% of their income from "qualified" sources, primarily energy and natural resource activities. MLPs do not pay any income tax as long as they make quarterly distributions of at least 90% of their earnings to shareholders (called unit holders in the partnership structure). However, Regulated Investment Companies (RICs) are prohibited from having more than 25% of their investments in MLPs. Most mutual funds, ETFs, and CEFs are organized as RICs which prevents them from being pure MLP plays; these funds usually round out their portfolios with subsidiaries and affiliates of MLPs.
However, fund companies on Wall Street are creative and they figured a way around the RIC limitation by organizing as C-corporations. These corporations may invest exclusively in MLPs but must pay corporate income tax. This may not be as detrimental as it sounds since MLP investments, as discussed below, offer ways to minimize taxes.
Most MLPs operate in the "midstream" portion of the energy production cycle which involves the storing, transporting, or processing of energy (as opposed to "upstream" exploration or "downstream" retail sales). These MLPs typically have huge infrastructure expenditures, such as pipelines and processing plants. In terms of taxes, these infrastructure investments can be depreciated each year. When a MLP pays out a distribution, the lion share comes from depreciation allowances and is treated by the IRS as return of capital (ROC). This return of capital serves to reduce the basis associated with the MLP purchase and taxes are not paid until the MLP is sold.
So when a C-Corp fund receives a distribution from one of its constituent MLPs, the fund is able to write down the basis of the investment for the ROC portion of the distribution. Over the years, the fund often builds up relatively large amounts of deferred tax liability that will not be realized until the MLPs are sold. By IRS rules, these liabilities reduce the Net Asset Value (NAV). Astute investors recognize that the NAV has been "artificially" lowered, so these investors may be willing to pay a premium over the reported NAV. This is why MLP CEFs often sell at premium prices.
Return of Capital is an important concept when investing in MLPs and deserves some additional discussion. One of the key things to realize that the definition of ROC is not the common sense idea of receiving back your own funds but is instead based on accounting and tax rules. Not all ROC is considered "bad". Because of depreciation, MLPs often have much more cash that can be used for distributions than is recorded as income. By accounting rules, this cash is designated as "return of capital". This type of ROC is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase.
Another way to avoid the limitations of RICs is to structure the investment as an Exchange Traded Note (ETN). In ETNs, the issuing company promises to provide the buyer with the same return as he would have received from the index (less management fees) but the ETN does not actually own the underlying MLPs. Thus the 25% restriction does not apply. However, since there is no underlying collateral other than the credit of the issuing company, ETNs have credit risk. All the issuing companies (JP Morgan, UBS, and Credit Suisse) have excellent credit rating so the probability of a default is very small but is not zero. If the issuing company was to experience a credit downgrade, then it is likely that the ETN would lose value.
Thus, the four types of fund structures that I will analyze are:
- CEFs structured as RICs
- CEFs structured as C-corporations
- ETFs structured as a C-Corporations
Because of the relatively high yield, MLPs have gained popularity over the last few years. Many funds were launched in 2011 or later and do not have a long track record. I will limit my analysis to funds that have at least a 3 year history. My other selection criteria were:
- The fund must be fairly liquid and trade an average of 50,000 shares per day
- The fund must have a market cap of at least $200M
The following funds passed all my criteria:
- Kayne Anderson Midstream Energy (KMF). This is a CEF structured as a RIC. The fund sells at a discount of 10.2%, which is well below the average discount of 2.2%. The portfolio consists of 80 holdings, 85% of which are invested the midstream/energy sector consisting of pure MLPs as well as MLP subsidiaries and affiliates. The fund uses 20% leverage and has a high expense ratio of 3.9%, including interest expenses. The distribution is 5.8% with no return of capital.
- Kayne Anderson Energy (KYE). This is a CEF structured as a RIC. The fund sells at a 6% discount, which is unusual since the fund typically sells for an average premium of 1.5%. This fund has 89 holdings with 90% in MLP associated companies in the energy sector. The fund utilizes 31% leverage and has a very high expense ratio of 4.4%, including interest payment. The distribution is 7.4% with no return of capital.
- Kayne Anderson MLP (KYN). This CEF is structured as a C-corporation and sells for a premium of 13.2%, which is higher than its average premium of 8.5%. It holds 67 MLP securities and uses 33% leverage. The expense ratio is a very high 4.4%, including interest. The distribution is 6.3% consisting of income and non-destructive ROC.
- Fid/Claymore MLP Opportunity (FMO). This CEF is structured as a C-corporation and sells for a 4% premium, which is slightly below the average premium of 7.1%. This fund has 45 holdings, all MLPs. It employs 24% leverage and has an expense ratio of 2.1% including interest payments. The distribution is 7.8% consisting mostly of return of capital. However, since the NAV has increased over the last year, this ROC is not considered destructive.
- ClearBridge Energy MLP (CEM). This CEF is structured as a C-corporation and sells for a 0.9% premium, which is below the average premium of 3.4%. The portfolio has 38 holdings, all of which are MLPs. The fund utilizes 21% leverage and has an expense ratio of 1.9%, including interest payments. The distribution is 6.3%, which is mostly non-destructive return of capital.
- Tortoise MLP Fund (NTG). This CEF is structured as a C-corporation and sells for a discount of 5.6%, which is much lower than the average premium of 1.2%. The fund holds 33 MLPs and uses leverage of 21%. The expense ratio is 2.3% and the distribution rate is 6.5%, consisting mostly of non-destructive ROC.
- Cushing MLP Total Return Fund (SRV). This CEF is structured as a C-corporation and sells for a whopping 21.7% premium, which is much higher than its average premium of 14.2%. The fund holds 48 securities with about 67% invested in MLPs, 23% in cash alternatives, and the other 10% in other equity and preferred shares. The fund uses 26% leverage and has an expense ratio of 3.3%. The distribution is a large 11.1% (which is likely the reason for the large premium), most of which is non-destructive ROC (but the NAV has been struggling lately).
- ALPS Alerian MLP ETF (AMPL). This is an ETF that tracks the Alerian MLP Infrastructure Index, which consists of 25 pipeline and processing MLPs. This is one of the few ETFs that track MLPs (most are structured as ETNs). AMPL is structured as a C-corporation to avoid the 25% limitation for MLP ownership. This has become one of the fastest growing exchange traded products, with an average daily volume of over 3 million shares. This ETF does not utilize leverage and has a low expense ratio of 0.85%. It has a yield of 6%.
- JPMorgan Alerian MLP Index (AMJ). This is an ETN that tracks the Alerian MLP index, which consists of the 50 largest MLPs. An increased level of caution should be exercised if you plan to purchase AMJ. In June, 2012 JP Morgan decided to cap the number of shares that were issued for AMJ. This was very unusual for an ETN and effectively changed the ETN into a closed-end product. With the number of shares fixed, the price is based on supply and demand and the ETN can sell at a premium. At the current time, AMJ is selling very near its NAV but it could deviate from the NAV in the future. The expense ratio is 0.85% and the yield is 4.8%.
- UBS E-TRACS Alerian MLP Infrastructure (MLPI). This ETN tracks the Alerian MPL Infrastructure Index, which is a more concentrated portfolio of 25 pipeline and processing MLPs. It has an expense ratio of 0.85% and a yield of 4.5%.
- UBS E-TRACS MLP Wells Fargo (MLPW). This is an ETN that tracks the Wells Fargo MLP Index, which is a broad based index with 65 energy MLPs, including 7 general partnerships. It has an expense ratio of 0.85% and a yield of 4.6%.
- Credit Suisse Cushing MLP (MLPN). This ETN tracks the Cushing 30 MLP Index, which is an equal weight index comprised of 30 midstream energy MLPs. The index uses a proprietary valuation technique to select the companies that are included in the index. MLPN has an expense ratio of 0.85% and yields 4.4%.
- UBS E-TRACS Alerian Natural Gas MLP (MLPG). This ETN tracks the Alerian Natural Gas MLP Index, which is an equal weight index of 20 natural gas MLPs. It has an expense ratio of 0.85% and yields 4.9%.
To assess the risk-adjusted return of these MLP funds, I used the Smartfolio 3 program. Figure 1 provides the rate of return (called Excess Mu on the charts) in excess of the risk free rate. This rate of return is plotted against the historical volatility over the past 3 years for each of the MLPs.
Figure 1. Risk vs. reward over past 3 years
The legend associated with the figure is:
- Red dots indicate CEFs with a C-corporation structure
- Blue dots indicate CEFs with a RIC structure
- Green dots indicate ETNs
- Black dot indicates an ETF with a C-corporation structure
As illustrated by the figure, over the past 3 years, there has been a wide range of returns and volatilities associated with MLP funds. A fund like FMO has a relatively high volatility but also has a large return. Was the return commensurate with the volatility risk? To better assess the relative performance, I calculated the Sharpe ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with the AMLP, which is the most actively traded of all the funds. If an asset is above the line, it has a higher Sharpe Ratio than AMLP. Conversely, if an asset is below the line, the reward-to-risk is worse than AMLP.
Some interesting observations are evident from the figure. First off, the ETF structured as a C-corporation had the lowest volatility among all the funds but also had a relatively low return. On a risk-adjusted basis, most of the funds had better performance than AMPL. All the ETNs (green dots) were tightly grouped, which is not too surprising since they track similar indexes. The ETNs generally had excellent risk-adjusted performance. Among the CEFs, there were wide variations among the best and worst performers and it does not appear to matter if the structure is a C-Corporation or a RIC. KYN had the best performance while SRV (the CEF with the largest premium) had the worst performance.
Next I wanted to see if the risk-reward characteristics were maintained over a more recent period when the S&P 500 was enjoying a rip-roaring bull market. I reduced the look-back period to 1 year and re-ran the analysis. The results are shown in Figure 2.
Figure 2. Risk versus reward for covered call funds over one year
During the past year, the MLP ETF (AMLP) had much better risk-adjusted performance, beating out the all the CEFs, with the exception of KYN. As with the 3 year period, the ETNs were tightly bunched and all (with the exception of AMJ) had great risk adjusted performance. AMJ tended to lag behind the other ETNs but still managed to best most of the CEFs. The CEFs had good performance during the last year, just not as rewarding as some of the other funds. During this period, the C-corporations generally did better than RICs, due mostly from their higher concentrations of pure MLPs.
Before leaving MLPs, I should mention one of the tax filing advantages of using funds rather than individual MLPs. For individual MLPs, you will receive a K-1 partnership form for each partnership. The K-1 form is vastly different and much more complicated than the simple 1099 form for stock dividends. Although MLPs try to make filing a K-1 as easy as possible, it is still complex and confusing. To make matters worse, K-1 forms are not required to be issued until 15 March, much later than the January 31 date for 1099 forms. Thus, you may need to delay your tax filing until you receive all your K-1s. If you invest in MLP funds, you don't have to deal with K-1 forms; your distributions are reported on simple 1099 form, just like your other investments.
The bottom line is that MLPs have been good investments during the past 3 years. The ETNs have generally had the best risk-adjusted performance. Any of these ETNs have had similar performance but personally I like MLPN the best. Among the CEFs, KYN has clearly had the best risk-adjusted performance.
No one knows what the future will hold. MLPs usually have large amounts of debt associated with maintaining their infrastructure, so higher interest rates present risks for this asset class. However, for risk tolerant income investors, I think MLPs are worthy of serious consideration.