Investing in MLPs
A master limited partnership, or MLP, is a company that’s specially structured so that it doesn’t pay corporate taxes. It’s fundamentally a publicly traded limited partnership. MLPs can only engage in certain types of businesses and must generate at least 90% of their income from qualifying sources, as designated by the Internal Revenue Service. Some examples of qualifying income sources include natural resource activities, interest, dividends, capital gains, rental income and capital gains from real estate, and income from commodity investments. Most, but not all, MLPs are engaged in energy infrastructure such as natural gas processing, pipelines, and other energy transportation.
Most MLPs pay out a significant amount of their excess cash flow in the form of distributions (similar to dividends) to unitholders. To the extent that the distributions to unitholders exceed the recorded net taxable income of the partnership (which is often the case), the distributions are treated as a return of capital under the tax code and aren’t taxed when received. The distributions serve to lower the cost basis of the security, and taxes are recognized when the unitholder sells.
Because MLPs usually pay a certain amount of cash out every quarter, they tend to trade on a yield basis—”yield” being the cash generated per unit divided by unit cost. For example, Targa Resources Partners LP’s (NGLS) last distribution was $0.745 per unit. To get the annualized yield, take $0.745 * 4 (as distributions are paid quarterly) and divide by the unit price of $60.08 (as of April 11, 2014). The yield is ~5.0%. All else being equal, as distributions grow, you could expect the value of the underlying unit to increase. All else being equal, investors generally require a higher yield from riskier and smaller businesses. Plus, investors may also require a lower present yield if the underlying business is expected to grow significantly.
One alternative to investing in MLPs directly is to invest in MLP exchange-traded funds (or ETFs). An ETF can hold many different asset classes, including stocks, bonds, commodities, and derivatives. ETFs trade closely to the market value of the sum of all their underlying holdings or NAVs. Most ETFs are passive vehicles that aim to track an index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.
Investing in an ETF is a way to gain exposure to a portfolio of MLPs without actually buying or selling the individual stocks and one easy way to gain diversified exposure to the sector. For example, the Alerian MLP ETF AMLP owns the stocks of well known MLPs like Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), and Plains All American Pipeline (PAA). The benefit to owning an ETF is that the investor doesn’t have to manage a portfolio of individual stocks. Plus, MLPs owners must file a separate tax form (K-1) for each MLP name they own, and this isn’t necessary if they invest through an MLP ETF, where investors fill out a normal form 1099.
One downside to investing in ETFs is that they involve an expense ratio, which is the total percentage of fund assets used for administrative, management, advertising, and all other expenses. An expense ratio of 1% per annum means that each year, 1% of the fund’s total assets will be used to cover expenses. The expense ratio doesn’t include sales loads or brokerage commissions. ETFs usually have a low expense ratio (compared to actively managed funds). For example, the Alerian MLP ETF (AMLP) has an expense ratio of 0.85%. Plus, many MLP ETFs are structured as C-Corps and must recognize some tax expenses at the fund level, which can significantly affect returns.
The largest MLP ETF fund is the Alerian MLP ETF (AMLP), which tracks the Alerian MLP Index, a capitalization-weighted composite of 50 energy MLPs. Other MLP ETFs include the Yorkville High Income MLP (YMLP), the Global X MLP ETF (MLPA), the Yorkville High Income Infrastructure MLP ETF (YMLI), and the Global X MLP & Infrastructure ETF (MLPX). Note that these other MLP ETFs all have significantly smaller market caps than AMLP.
We’ll discuss these major MLP ETFs in the following parts of this series.