A Rush Of MLPs

July 14, 2010

Watching the deluge of filings surrounding MLPs is a little like going to a Rush concert.

I know they're great. For ages, I've been telling people they're great. Yet it's still disorienting when I see so many other people getting it at once.

In the past few months, ETF providers have gone nuts for MLPs, or "master limited partnerships." In June, both ALPS and Van Eck filed for MLP exchange-traded funds, while in the past week alone, UBS launched two new MLP-centric ETNs.

But if you're not still silently decrying my musical tastes, then you're probably wondering: What the heck is an MLP?

An MLP is a limited partnership that trades on an exchange, just like a stock. But it's not just any partnership. To qualify, a business must generate 90 percent of its income from the natural resource sector, including oil, gas, coal—even timber.

MLPs engage in all sorts of businesses, but generally, they adopt the "toll-road" strategy to commodities, making money not from the actual oil or gas itself, but from fees based on the volume they process. (Examples include coal miners, propane retailers, or LNG or crude oil tanker operators.) This quirk protects MLPs from volatility spikes in commodity prices, since their revenues depend much more on underlying demand trends than the spot markets.

There are some tax benefits (and headaches) associated with MLPs that I won't get into here, but I will say this: Because MLPs are partnerships and not corporations, they "pass through" income to investors without paying any corporate-level taxes. That means, like REITs, MLPs can make significant payouts ("distributions") to investors whenever the business performs well. And those payouts have remained steady and high for several years now, with yields hovering between 5 percent and 9 percent a year.

So if oil majors are the dependable “Abbey Road” of the energy space, and wildcatters are the frenetic, volatile “London Calling,” then MLPs are like Rush's magnum opus, “2112”: offbeat, a little complicated, and definitely not for everybody. But for those in the know, they consistently offer satisfying rewards, year after year.

While I'll save a detailed roundup of the many ETPs either launching or currently available for our upcoming issue of the Exchange Traded Funds Report—you do subscribe, right?—one recent rollout caught my eye in particular.

Earlier this week, UBS rolled out its E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEArca: MLPL). MLPL tracks the Alerian MLP Infrastructure Index, a market-cap-weighted benchmark of 25 energy infrastructure firms.

What's interesting about MLPL is that it offers the market's first leveraged MLP play, and it does so with a new twist on the idea of leverage itself. The ETN provides twice the compounded monthly performance of its benchmark—not twice the daily performance we're so used to seeing from other funds. So, according to UBS, MLPL's current annual yield is 12.89 percent, or a little less than twice that of its underlying benchmark.

But before you get too excited, there are still some caveats to remember. Even though MLPL rebalances monthly instead of daily, it's still a leveraged fund, and its returns aren't quite as simple as "twice the underlying benchmark." Run through the prospectus to see examples of how the math breaks down.

Plus, like all MLP ETNs, MLPL pays out a quarterly coupon based on the sum of the cash distributions of all its various MLP holdings. In MLPL's case, those distributions are leveraged, too. But cash distributions for MLP ETNs are actually taxable as regular income (as opposed to distributions for individual MLPs, which count as "return of capital" and are therefore mostly tax-deferred). So the yield you see isn't necessarily what you'll get.

And, of course, there’s the big downside common to all ETNs: their very real credit risk. Lest we forget, a few ETNs never made it out alive from the Lehman Brothers implosion, and I know more than one adviser who has sworn to never touch them again, for that very reason.

Still, MLPL could become an interesting trading play, and while it's too early to tell whether it offers a smarter take on the MLP sector, I’m keeping my eye on it—and turning up "Tom Sawyer." Rock on.


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