By Michael Rawson
Interest in publicly traded master limited partnerships has grown considerably in recent years. The number of energy and infrastructure MLPs has grown from about 17 to 75 in the past 15 years while the outstanding market capitalization has gone from $7 billion to $220 billion. Gaining access to this growing market through diversified products was limited to a handful of closed-end funds. But in the past two years, five mutual funds and eight exchange-traded products have launched to cover the space. The growing interest in MLPs has been driven by changes in regulation, the search for higher yields in a low interest-rate environment, and disappointment in the diversification benefits of traditional asset classes in the wake of the financial crisis. MLPs offer tax advantages, attractive yields, and low correlations to equities. With the additional tax complexity of MLPs, more due diligence than normal is required. But those willing to do the work will be rewarded.
A Better Mousetrap?
Modern Portfolio Theory is based on the notion that you can get better risk-adjusted returns by diversifying between uncorrelated assets. But the advantage may be diminished as the light gets shone on these smaller and undiscovered assets and they become widely followed, indexed, or even marketed within an ETF. Thus, the act of investing based on past information can change the results that we get in the future. Call it the Heisenberg Uncertainty Principle of investing.
Take REITs, for example. Between 1996 and 2006, the correlation between REITs and the S&P 500 was only 35%. The first REIT was added to the S&P 500 in 2001, and several followed throughout the decade. At the same time, a number of studies came out touting the diversification benefits of REITs. Over the past three years, the correlation spiked to 85%. The previously low correlation resulted in part from the fact that the performance of REITs was unrelated to the performance of large-cap and technology stocks that dominated the performance of the S&P 500 during that period. While the recent rise in correlation has been observed in a number of asset classes because of increasing global macroeconomic risks, there is also something to be said of the effect of indexing. As more assets have flowed into passive index funds and as REITs have increasingly become part of those indexes, the correlation has increased. James Xiong of Ibbotson Associates labels this phenomena trading commonality, and his research suggests that it has reduced the diversification benefit from correlation.
To analyze the benefits of an asset allocation to REITs and MLPs, we started with a base portfolio invested in large- and small-cap U.S. stocks, international developed- and emerging-markets stocks, as well as bonds and commodities. The portfolio was rebalanced annually to its initial weights. Between 1996 and 2006, the portfolio returned a compound annualized return of 8.9%. If we add a 10% allocation to REITs (reducing the allocation to the other assets but keeping their proportions the same), the return improves to 9.7%. However, between 2006 and 2011, the portfolio with the 10% REIT allocation returned 3.5% compared with 4.0% for the no-REIT portfolio. While risk decreased in the earlier period, it increased in the later period. The benefits of REITs did not hold up as promised.
If Not REITs, How About MLPs?
Conducting the same experiment with MLPs showed a similar improvement between 1996 and 2006, with the portfolio return moving to 10.0% from 9.0%. But the most recent period also showed an improvement, to 5.0% from 4.0% as well as a reduction in risk in both periods.
But Will the Diversification Benefits Hold Up?
There are several reasons to expect that MLPs will keep their status as a portfolio diversifier. There is a large segment of the investment industry that will likely continue to avoid MLPs for tax reasons, and MLPs are not likely to be added to broad stock indexes. Investments in corporations are subject to double taxation - once at the corporate level and then again at the investor level. A special exemption in the tax code allows both REITs and MLPs to avoid the taxation at the company level but restricts operations to certain qualifying activities. At the investor level, taxation of REITs and common stocks is similar as investors will receive a 1099 for their dividend income. But MLPs are taxed as pass-through entities, meaning investors are taxed based on their share of the MLP's deductions and income. Because of an allowance for depreciation, a large portion of an MLP's distribution is treated as a return of capital, which lowers the investor's cost basis in the MLP. This lower cost basis may also be stepped up upon death, making MLPs a valuable estate-tax-planning instrument. Instead of a 1099, investors receive a K-1 reflecting their interest in the partnership. However, investors are required to file a state income tax return in every state in which the MLP does business. Enterprise Products Partners L.P.EPD does business in 36 states. Holding an MLP in a tax-deferred account can lead to other tax complications, as highlighted in this article by Christine Benz.
These tax issues make MLPs less desirable in a broad index. Since indexes are meant to be investable, including MLPs in an equity index would make it less appealing to many investors. The Standard & Poor's 500 Index is designed to include only common equity, REITs (other than mortgage-REITs), and certain business-development companies. MLPs are technically not common equity but rather publicly traded partnership interests. Additionally, limited partners in MLPs do not have the same corporate governance or voting rights as stockholders in a corporation. While the 2004 American Jobs Creation Act increased the percentage of MLPs that mutual funds can hold, mutual funds still tend to avoid MLPs. For example, just 6% of the largest MLP, Enterprise Products Partners (NYSE:EPD) is owned by mutual funds compared with 29% for Exxon Mobil (NYSE:XOM) and 24% for Citigroup (NYSE:C).
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.