Find Lower Market Volatility In A Basket Of MLPs

Includes: AMJ, AMLP
by: Greg Group

Investors seeking income in today’s market face two major obstacles: low interest rates and high volatility. Income investors are seeking stable income with a lower level of volatility. The Dow Jones Industrial Average (NYSEARCA:DIA) has a 3 month volatility of 26.3%. So you can look at dividends to lessen volatility with the Vanguard High Yield Dividend Index (NYSEARCA:VYM) but it has a 3-month volatility of 23.4%.

What’s an investor to do to escape these market swings? The solution is to look for investments that provide a secure cash flow like a toll road. I suggest looking at master limited partnerships (MLPs) as a solution. MLPs pay hefty dividends, which makes them particularly attractive at times of low interest rates. Moreover, they are like toll booths, generating income from transporting commodities like oil as opposed to producing them, which insulates them from price volatility and makes their cash flow smooth. Instead of investing in several MLPs, which can be a tax headache, look at ETFs/ETNs that focus on a basket of MLPs.

The two ETFs that I like are ALPS Alerian MLP Infrastructure Index (NYSEARCA:AMLP) and the J.P. Morgan Alerian MLP Index (NYSEARCA:AMJ). AMLP has a 12 month return of 7.6% with a low 3-month volatilty of 10.7% and distribution yield of 6.18%. AMJ has a 12 month return of 9.4% with a low 3-month volatilty of 17.3% and distribution yield of 5.1%.

AMLP has a very stable monthly return, as shown in the chart below. AMLP holds all 25 constituents of the Alerian MLP Infrastructure Index. The index is capped, float-adjusted, and weighted by market capitalization. At second-quarter end of 2010, AMLP devoted 43.8% of assets to petroleum transportation, 34.2% to interstate natural gas, and 21.5% to intrastate natural gas. AMLP levies a 0.85% annual fee. The fee is in line with existing MLP ETNs and is significantly cheaper than its closed-end fund and mutual fund counterparts.

The MLP's full distribution is passed on to investors as dividends from AMLP, but because the fund pays annual corporate taxes on its received distributions, the net asset value is effectively decreased by the value of the tax. The index calculation does not account for tax deductions, so distributions will necessarily create a level of tracking error.

Dividends will retain the character of the original MLP distributions for tax purposes. A majority share will be considered return of capital and tax deferred. This will cause a downward correction in the tax basis of the investors' shares. If requisite holding periods are satisfied, the remaining taxable portion of distributed dividends will be considered "Qualified Dividend Income" and taxed at long-term capital gains rates up to 15%.

A suitable alternative to AMLP is the J.P. Morgan Alerian MLP Index (AMJ). This ETN tracks the Alerian MLP Index, which is a market-cap-weighted and float-adjusted index of 50 prominent energy MLPs. The constituent companies are screened for minimum quarterly distributions, so the holdings remain focused on the largest distribution providers. The average market-cap holding is around $3 billion, and the index will consider firms with unadjusted market capitalizations as low as $500 million. These inclusion factors give AMJ a small-cap and value bias. At 0.85% per year in annual expenses, this is not the cheapest ETN on the market. We think that its limited tracking error and the elimination of MLP tax-reporting complications, however, make AMJ a reasonable way to gain exposure to this high-yielding niche corner of the market.

For those not familiar with an ETN, it is similar to an exchange-traded fund in that it trades on an exchange, tracks the returns of a specific index, and the units are continually created and redeemed based on market demand. That is where the similarities largely end. An ETN is actually a bond whose principal value fluctuates with the price of the underlying index and whose interest payments are a function of the income being paid by index constituents (less fees, of course).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.