MLP ETFs are growing in popularity, but their structure and interest rate-sensitivity make a lot of them especially risky.
Examining the types of partnership, the benchmark index and the portfolio composition helps identify lower-risk investments that can still earn a yield of 5% or more.
These three MLP ETFs focus largely on more conservative limited partnerships and/or midstream pipeline companies with a strong and steady dividend history.
Investments focusing on master limited partnerships (or MLPs) have performed very well recently. Many have seen double-digit returns year-to-date, and a few are even north of 20%. As a result of the popularity boom of MLPs as an investment, we've seen a number of vehicles in the ETF space popping up. Many are still building up their asset bases, so the limited tradability, coupled with the more volatile nature of MLPs in general makes these types of investments higher-risk.
However, it's still possible to achieve a high return or high yield with below-average risk. A lot of these ETFs are young, and getting reliable risk data on them can be a bit of a challenge, but looking at available data, the composition of the portfolio, and the type of index they're trying to benchmark can all give us clues as to which ones will be more conservative than the others.
ALPS Alerian MLP ETF (AMLP)
The ALPS Alerian MLP ETF not only is the biggest MLP ETF out there (and by a fair margin), but also combines low expenses (0.85%) and an above-average 5.80% yield.
The Alerian MLP ETF tracks the Alerian MLP Infrastructure Index - an index comprised of 25 mid- and large-cap market-weighted MLPs. This means you're getting some of the bigger more conservative energy names out there, like Enterprise Products Partners (NYSE:EPD) and Kinder Morgan Energy Partners (NYSE:KMP) - currently the two largest holdings in the ETF - at almost 20% of total assets.
Further, the Alerian MLP ETF focuses solely on limited partnership units, which tend to be more conservative than the potentially more aggressive general partnership units. Additionally, the ETF's focus on midstream pipeline companies further limits risk.
According to Yahoo Finance, the Alerian MLP ETF currently has a beta of 0.32 and a Sharpe ratio of 1.45. While beta can be a bit of an incomplete measure, these numbers suggest an investment that provides above-average risk-adjusted returns with below-average risk.
First Trust North American Energy Infrastructure ETF (EMLP)
The First Trust North American Energy Infrastructure ETF doesn't look all that dissimilar to the Alerian MLP ETF until you look under the hood. First Trust looks to invest broadly in MLPs of all sizes, and not just the largest ones. The types of investments this ETF makes are also different, as its holdings are fairly evenly divided between the energy and utilities sectors (whereas Alerian focuses solely on energy). Additionally, the First Trust ETF is more broadly diversified, which also helps limit portfolio risk.
The dividend yield of 3.0% is lower than the yield on some of the MLP ETFs in this space, but that can be attributed to the large quantity of utilities in the portfolio and their more conservative (although interest rate-sensitive) nature.
UBS ETRACS Alerian MLP Infrastructure Index ETN (MLPI)
I'm cheating here a little bit adding an exchange traded note to the list, but given the very similar nature of ETFs and ETNs, the UBS ETRACS Alerian MLP Infrastructure ETN is worth profiling.
This ETN also maintains the Alerian MLP Infrastructure Index as its benchmark, which means it also focuses on the more conservative midstream pipeline companies and the more conservative limited partnership units. Its holdings are again similar to that of the Alerian MLP ETF, but ETNs are built differently than ETFs considering factors such as underlying securities in the investment itself and tax structures. Therefore, performance and volatility can be different.
Since the ETN's inception in 2010, it has produced a strong, steady and incrementally growing quarterly dividend. Dividend growth has consistently been in the 1%-2% range quarter-over-quarter, providing investors a predictable income stream with several years of history backing it.
ETFs vs. ETNs
I mentioned above that ETFs and ETNs are very similar, but not quite the same. There are some important differences to note between the two, and it's worth reviewing those differences here.
Both ETFs and ETNs appear similar when trading. They trade the same way on a stock exchange, and can be bought and sold throughout the day. The primary difference is the underlying security. ETFs will actually hold the security that is being tracked, whether that's a stock, bond, etc. ETNs are more like bonds in that they are actually unsecured debt notes issued by an institution. ETNs, like bonds, can be held to maturity or bought and sold throughout the day.
The primary risk that comes with an ETF is the risk of loss associated with the underlying securities. With an ETN, the primary risk is a default by the underlying issuer.
With an ETF, tax implications are similar to those of mutual funds. An ETF can issue a dividend or capital gain at any time, and that gain or dividend would be taxable to the owner when it is incurred. That means you could experience a taxable event throughout ownership of the ETF all the way until the position is liquidated. With an ETN, since there is no buying or selling of the underlying asset, there is no taxable event until the position is liquidated. Therefore, taxes are not actually owed until a sale is made, which could be in a month or 10+ years.
Tracking error is also a risk. ETFs may have a challenge tracking their underlying index due to buying and selling securities throughout the day, as well as transaction and management fees. All of these come at a cost to the ETF, and the result is the ETF's inability to perfectly match its benchmark. ETNs don't have this tracking risk, because there is no underlying trading of securities. Again, it's just like a bond that can be held until maturity.
So, which is better? Like most cases, it depends on your situation. Your investment horizon and tax bracket should be considerations, as capital gains and distributions are treated differently. ETFs are also far more prevalent than ETNs. Most ETFs are traded frequently enough that liquidity isn't an issue. The potential for a lack of buyers and sellers of ETNs could mean a potential difficulty to trade. Spreads on trades could be larger for ETNs than ETFs as well.
Growth in popularity means more investors are exploring MLPs as part of their portfolios and new offerings are popping up regularly. Given the risk of individual holdings and the interest rate-sensitivity of such securities, the risk level of such investments can be more than some investors are willing to stomach.
However, if one fully examines the composition, tax structure and income predictability of MLPs, it's easier to find ones that provide a solid yield and return potential at below-average risk.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.