Advisor Views On MLP Funds & Notes

November 11, 2014

Straddling fixed income and energy growth is attractive.

[See our upcoming December edition of ETF Report for a special MLP supplement.]

Erman Civelek, CFA

Senior Vice President, Investment Strategist

The MDE Group

Morristown, N.J.

AUM: $1.3 Billion

 

How does your firm use MLP ETFs and allocations?

We use it as what we call a hybrid asset class spanning income and growth. Traditionally, investors have chosen equities to give them long-term growth. MLPs fall right in between those two. We have a bucket in our risk models in which it is right between equities and fixed income. Within that bucket, we’re looking at MLPs to provide both income and growth elements in our portfolios.

The income is pretty attractive. You’re starting the year with 5-6% type income, and then on top of that, you’re looking to add midsingle digits, growth opportunities. Obviously it doesn’t come in a linear fashion. Some years you lose money, some years you make more than your expected return.

Maybe you just answered my second question, which is, do you treat MLP funds as a fixed-income play or an energy play, or both?

We use it as one of the fixed-income alternatives, but we don’t categorize it as fixed income because it doesn’t have a fixed income. What we’re looking to do is really more thematic, which is to take advantage of the energy infrastructure buildup in United States. We’re looking to invest in companies that build, acquire and operate these transportation assets. We focus on the midstream partnership space that acts as a fee-based, toll-road-type business, where its revenues are indexed inflation, and they look to grow with inflation.

What particular ETFs or ETNs do you use?

We’ve used multiple vehicles over years. And it really depends on whether the investor wants to take credit risk, leverage risk or the burden of extensive K-1 reporting. The cleanest and the most client-friendly format is the ETF format, which gives you no credit risk and it gives you daily liquidity, no leverage, low fees. But you’re paying a price for double taxation, because the companies that have more than 25% in MLPs have to withhold taxes. And that creates a drag on performance in up markets.

For ETFs, we use the Alerian MLP (AMLP). And in terms of the next bucket, which would be the exchange-traded note, we use Etracs Alerian MLP Infrastructure ETN (MLPI). With ETNs, you take a credit risk of those institutions, you’re a line item on their balance sheet as a borrower, so you’re really holding a credit instrument. But also, you get ordinary tax rates because you’re holding a bond. We found those two elements less appealing, so we really haven’t done too much investing in the ETN space because of the investment committee’s goal of not introducing credit risk into the equation.

What’s the tax difference between an ETN and ETF?

With an ETN, you’re holding a note that’s issued by a large bank. And the return on that would be taxed at the ordinary tax rate, whereas with an ETF, it’s tax advantaged. Most of your return is deferred in terms of capital, so it would qualify as a tax advantage.

 

Rob Glownia

Quantitative Analyst

Riverfront Investment Group

Richmond, Va.

AUM: $4.8 Billion

 

How do you use MLP exchange-traded products in your asset allocation models?

We have MLPs in our asset allocation process for two reasons: First, attractive relative yield: MLPs offer distribution yields of roughly 4-5%, which we find attractive relative to other equity yield-producing vehicles, such as real estate investment trusts (REITS) and utilities. Secondly, more attractive relative growth: MLPs have traditionally grown their distributions 5-10% annually. Other income-producing vehicles—such as bonds, REITS and utilities—typically grow their coupons or dividends at much lower rates, if they grow them at all. Furthermore, we anticipate distribution growth rates should accelerate over the coming years due to the rapid growth of energy infrastructure (pipelines and storage facilities) in the shale gas regions in the country.

Is this a fixed-income play or an energy play or both?

In general, MLPs will have some sensitivity to both rates and commodity prices. However, the main rationale for owning them is for the reasons mentioned above. You get an attractive relative yield that comes with growth opportunities as well.

Do you prefer the ETF or ETN structure when it comes to these products, and why? Any specific products you use that you can single out?

We own a blend of the Global X MLP & Energy Infrastructure (MLPX), Credit Suisse Cushing 30 MLP ETN (MLPN), and Barclays ETN+ Select MLP ETN (ATMP) in our portfolios. MLPX is an ETF, while the other two are ETNs. None of these products issues a K-1, they’re not subject to unrelated business income tax, nor are they structured in a way that could potentially lead to punitive capital gains tax withholdings.

However, there will still be capital gains taxes for the investor if the security appreciates, but these capital gains will not be held back at the corporate level.

At Riverfront, we have exposure limits in place for ETNs, because at the end of the day, you’re taking on the credit risk of that issuer.

In the ETF space, we believe Global X has created a unique product with MLPX in that it caps the limited partner  exposure to 25%, with the remaining 75% comprising the general partners. In our opinion, shareholders of general partners typically accept a slightly lower initial yield, but get a significantly higher distribution growth rate, which should lead to less susceptibility to rising interest rates.

Is there a particular part of the natural resource world you are more interested in than others?

The key here is to focus on energy infrastructure—pipelines, storage, etc. We prefer these assets because their revenues are more predictable, because they are generally long-term contracts and fee based, so they have less vulnerability to rising or falling commodity prices.

Are falling oil prices a concerns for you in regard to MLP funds?

Falling oil prices are definitely a concern, but per the comments just mentioned, there is some insulation from the volatility of energy prices. That said, the recent headlines have all been about Saudi Arabia trying to break the back of the U.S. shale boom, so we’ll continue to monitor how lower energy prices are affecting capacity and utilization rates.

 

Gary Pollock

Senior Managing Director, Portfolio Manager

First Republic Investment Management Inc.

San Francisco

AUM: $25 Billion

 

How do you use MLP exchange-traded products in your asset allocation models?

We have an allocation to “commodity/other” as an asset class, which, for my clients, consists mostly of energy infrastructure. We originally separated out this small class because of the tax characteristics of master limited partnerships.

Is this a fixed-income play or an energy play or both?

I call it an “income-oriented” investment with a play on energy—some of both.

Do you prefer the ETF or ETN structure when it comes to these products, and why?

The ETF structure has a tax drag associated with it that is eliminated with an ETN. Both can be used, though, in tax-deferred accounts without running afoul of the unrelated business income designation.

I think the data I have seen over the last year or two would suggest that the ETN structure will do better over the long run, but you have the added risk in the form of the credit risk of the issuer, and some folks don’t like that extra risk layer. These are indeed notes rather than equities in the true sense.

In particular, I’ve invested a lot in the Yorkville High Income MLP (YMLP), Yorkville High Income Infrastructure MLP (YMLI) and now RBC ETNs Linked to Yorkville MLP Distribution Growth Leaders Liquid PR Index (YGRO).

I like an intelligent approach to pooled investing rather than a simple market-cap index. I like the idea that the stocks in the three indices are reviewed each year for sustainability and suitability, and that they start off equal weighted. There is also attention paid to liquidity, especially with YGRO, so that the strategy is sustainable. The energy infrastructure sector is not a large sector, so liquidity, or the lack thereof, can be an important consideration.

Is there a particular part of the natural resource world you are more interested in than others?

I’m quite partial to energy, but then I worked as a chemical engineer for almost 20 years at Chevron. Energy is the largest commodity in the world by almost any measure and is the lifeblood of our modern economy. The geopolitical aspects along with the technical and economic aspects are fascinating to me.

Are falling oil prices a concerns for you in regard to MLP funds?

I’m an optimist and opportunist. When prices fall, that’s usually a good time to buy. I don’t try to hit the very bottom—if I do, it’s simply luck, but the values are much better near the bottom.

Of course, you have to have a long-term positive view on energy, and oil prices in particular, which I do. So much of the new oil production in the U.S.—and virtually all MLPs are U.S.-based—is in areas that didn’t have a lot of infrastructure where there’s still a tremendous need for investments in this type of business. I think it’s still a good growth sector, with above-average income because of the MLP structure.

 

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