By Stacey Morris
With all the recent transactions in the MLP space and consolidation of MLPs by their C-Corp parents, investors are understandably concerned about the implications for their MLP investments. Some investors are worried that MLPs face extinction, and others fear that they may be missing out if their energy infrastructure investment does not include corporations. But is there really reason for concern? In today's post, we wrap up our three-week series by breaking down what the changes in the MLP space mean for MLP investors and whether MLP investors should be worried based on their investment objective. We also discuss the broader implications of restructurings for MLP products and MLP performance.
As background, we discuss the two main types of MLP funds and compare MLPs and corporations. We focus mainly on the broad takeaways for investors in MLP-related products such as ETFs, mutual funds, closed-end funds, etc. For a more micro discussion of what restructuring transactions may mean for a direct investment in an MLP, see the commentary from Part 1. [Editor's Note: Alerian is not an investment advisor, and this piece is not intended to constitute investment advice. You must make your own investment decision.]
Background: Majority MLP funds vs. RIC-compliant funds.
Before we dive in, there are some important differences to note amongst MLP funds. Funds typically either own a significant amount of MLPs (80-100%) or have a weighting to MLPs of just under 25%. A fund that owns more than 25% MLPs is taxed as a corporation and can experience tax drag when performance is positive. A fund that owns less than 25% MLPs (a RIC-compliant fund) does not pay taxes at the fund level, allowing the entire return to be passed through to its investors. For even more context, see the Applied MLPs section of our MLP University. Suffice it to say, because of this dynamic, a fund with a 30-60% MLP allocation sees the worst of both worlds because it will presumably have a lower yield and the tax drag from being taxed as a corporation. Generally, investors wanting to access the space through a product like an ETF or mutual fund will have to choose between high MLP exposure or less than 25% MLP exposure. When you choose a RIC-compliant product, it is worthwhile to understand what is in the other 75%. Is it US energy infrastructure corporations? Canadian energy infrastructure corporations? Utilities? Refiners? Oil and natural gas producers? Whatever the answer may be, investors should understand what the other 75% is and how it fits within their investment objective.
How do MLPs and corporations compare?
The clearest distinction between MLPs and corporations is the tax efficiency of MLPs. Because MLPs do not pay taxes at the entity level, all else equal, they are able to pay a higher yield than their C-Corp counterparts as shown in the chart below. While we chose select names from each of the three categories as examples, we included indices for a broader perspective. The AMZI Index is a composite of energy infrastructure MLPs and the AMEI Index is a composite of North American energy infrastructure companies with pass-through entities (MLPs) capped at 25%. The yield of the AMZI is clearly higher than the yield of the AMEI, and for perspective, the average yield difference over the last five years has been 195 basis points1.
A misconception that we often hear is that C-Corps generally perform better than MLPs. While ONEOK (NYSE:OKE) has shown strong performance this year, the other corporations below have not. Similarly, some MLPs have performed much better than others. We would posit that performance depends on the company, as opposed to its structure. Year-to-date, the AMZI is outperforming the AMEI on a price-return basis, despite all the headline risk we've seen in the MLP space. However, on a five-year basis, the AMEI has returned 14.5% versus the AMZI at -13.0% (based on total return as of July 31st).
What fits better in your portfolio based on your objectives?
I want the yield and tax-deferred return of capital associated with MLPs."
In most of our conversations, investors have allocated to the MLP space for yield and the tax-deferred return of capital benefit. If that is your primary investment objective and you don't want to own MLPs directly2, then you will most likely want to own a product that is predominately MLPs. Though there are some exceptions, corporations generally have lower yields than MLPs. If you really want yield, then you should have no fear of missing out from owning a product that does not include corporations. Funds that predominately own MLPs are more suitable for taxable investors seeking after-tax yield.
I want broad exposure to energy infrastructure."
If you want broad exposure to energy infrastructure, you will want to own a product with both MLPs and corporations. For even broader exposure, you may want a product with US and Canadian energy infrastructure companies as well as MLPs. You will most likely want to access the space through a RIC-compliant product that owns no more than 25% MLPs. A RIC-compliant product is more suitable for total-return investors in a taxable account or for tax-advantaged investors.
Occasionally, we will hear investors express a desire to own both MLPs and some familiar corporations in a product. First, familiarity is not a good reason to include a company in your portfolio; for example, almost everyone has heard of General Electric (NYSE:GE)3… Within a predominately MLP product, adding a handful (10% weighting? 20%?) of corporations will not provide broad exposure and has the potential to dilute the yield. From a product standpoint, this "in-between" of mostly MLPs and a few corporations could lead to suboptimal yield relative to a 100% MLP product and suboptimal diversification relative to a RIC-compliant product. If you want both MLPs and corporations, a separately managed account (SMA) may be an attractive option, as you can avoid the RIC compliance issue, but SMAs typically require a high minimum investment.
What does fewer MLPs mean for your investment?
First, we should preface this discussion by acknowledging that some MLPs have been delisted and some may delist in the future as a result of consolidation, but we do not believe the MLP structure is going to be fully abandoned. The MLP model is still attractive to investors and is sustainable in the long run, particularly once IDRs have been addressed and capital discipline has been adopted (i.e. self-funding). As an example, last week's announcement that Energy Transfer Equity (ETE) would acquire Energy Transfer Partners (ETP) eliminates IDRs, and management discussed equity self-funding as a goal on the call. (As a reminder, ETE is an MLP.)
With that said, there are clearly fewer large MLPs today than there were at the start of the year. A decline in the number of large, investable4 MLPs could have implications for both active and passive products that predominately own MLPs. For example, investments may become more concentrated in the larger names, reducing diversification. The investment product's yield may also change as holdings change. That said, yield-focused investors will likely still want to own a product that predominately owns MLPs. RIC-compliant products likely see less impact overall and less impact to yield as MLP ownership is already less than 25%.
What are the implications for MLP performance?
A decrease in the number of large, investable MLPs can also have an impact on performance. If managed money with an MLP mandate has fewer options, money could theoretically crowd into the remaining MLP names, which could be supportive for performance. On the other hand, it's possible that funds that were predominately invested in MLPs may change their investment objective to become RIC-compliant, which again requires a 25% cap on MLPs. Changes to investment mandates could offset any uplift from MLP investments becoming more crowded.
For the last several months, the uncertainty surrounding potential transactions has likely weighed on performance and contributed to MLPs' lagging performance relative to the improvement in crude prices. With all the headline risk in the MLP space, some money has likely been sidelined, as some investors prefer to wait for this period of restructuring to resolve before allocating to the space or prefer names without a restructuring overhang. Arguably, the sooner the space can get through this "growing pain phase" or "identity crisis" or "restructuring period," then the better that may be for performance by alleviating uncertainty around restructurings and attracting fund flows into the space.
What about Alerian indices?
As an index provider in this space, we closely monitor changes in the energy infrastructure and MLP landscape. We have multiple benchmark indices that are formulaic, rules-based indices that rebalance according to their methodology guides, which are available on our website. Methodology guides are reviewed on a quarterly basis. Alerian intends that its benchmarks reflect industry trends and consults with key industry stakeholders in this process. An example is the recent launch of two new midstream indices (AMNA and AMUS) and a methodology change for the AMEI Index, which was renamed the Alerian Midstream Energy Select Index. Next week's post will discuss the energy infrastructure universe and these two new indices.
Some MLPs have been consolidated by their parents, leaving fewer publicly traded MLPs than there were at the start of the year. If you invested in a 100% MLP product for broad exposure to US energy infrastructure, then these developments may cause you to think twice about your holding. However, if you invested in MLPs for yield, then a direct MLP investment or 100% MLP product should still align with your objective. If you're looking for broad exposure to energy infrastructure or more focused on total return than yield, then you'll probably prefer a RIC-compliant product that owns both MLPs and corporations. The bottom line for investors in MLP products is, "Do you want yield (80-100% MLPs) or broad exposure (less than 25% MLPs and 75+% corporations)?"
1 In other words, the average yield for the AMEI has been 4.87% and the average yield for the AMZI has been 6.82%.
2 For a US taxable investor that is comfortable filing K-1s and state taxes and building a diversified portfolio, he or she will always be better off buying individual MLPs directly.
3 GE shares are down more than 40% over the last twelve months.
4 By investable MLPs, we mean those MLPs with sufficient size and trading volume to accommodate positions from large institutional investors.
Disclosure: © Alerian 2018. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.
Stacey Morris is the Director of Energy Research at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Ms. Morris engages with the investment community to increase awareness of the Alerian Index Series and support broader understanding of the role that midstream assets play in North American energy markets. Ms. Morris was previously the Investor Relations Manager for Alon USA Energy, overseeing investor communications for the corporation and its variable distribution MLP, Alon USA Partners. Prior to Alon, she covered the integrated majors and refiners at Raymond James as a Senior Associate in the firm’s Equity Research Division. Ms. Morris graduated summa cum laude with a Bachelor of Science in Business Administration from Stetson University, and is a CFA charterholder.