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Using Master Limited Partnerships to Enhance Portfolio Income

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by Cathy Pareto, MBA, CFP® – August 2012

The last five years in the markets have been nothing short of challenging, to say the least.  Global economic headwinds have left investors and advisors alike, looking for ways to improve investment results and boost income while more effectively managing risk.  As such, traditional stock and bond allocations are rapidly evolving to also include alternative asset classes such as REITs, commodities, currency funds, etc.,  which have historically provided diversification benefits.   Until recently, one such “alternative asset class”, Master Limited Partnerships (MLPs), was largely unavailable to most investors in a liquid format.  Today, MLP’s present an excellent opportunity for investors interested in income oriented strategies for their portfolio.

What are MLP’s?

Master Limited Partnerships are publicly traded companies that are integral to our country’s energy infrastructure.   MLPs focus on energy infrastructure such as pipelines, refineries, oil and gas storage and transportation. They tend to be involved in businesses that generate predictable cash flow, and as a result their distributions to investors are similarly consistent.  However, not all MLP’s are considered energy MLP’s.  There are also partnerships in the real estate industry,  mortgage industry, as well as investment and financial partnerships.

Energy MLP’s are typically involved in the “midstream” part of the energy sector, operating between the “upstream” (exploration and production) and “downstream” (refining and retail sales) segments.  MLP’s operate nearly 400,000 miles of pipeline assets in the US and transport millions of gallons of petrochemicals each year.  You may think of these companies as the “toll collectors” of the energy industry, collecting fees from energy companies (think ExxonMobil, BP) for transporting, storing and processing petrochemicals ultimately sold to consumers.

MLP’s were created in the early 1980’s, the first was the Apache Oil Company.  Today there are over ninety publicly traded MLP’s with a total market cap well above $300 billion.  As energy demand continues to grow, the industry is expected to expand too and more and more energy companies are considering the MLP structure.

Investment Opportunity?

The attractive yields and strong cash flows of MLP’s are among some of the reasons why investors may want to consider adding this asset class to a portfolio.  Historically speaking, MLP’s generate between 6-7% in annual yield.  Compared to a yield of less than 2% for the S&P 500.  The Alerian MLP Index has returned investors 17.6% annually on a total return basis from January 2000 to March 2012, while the S&P 500 delivered 2.5% per year during the same period.  MLP’s represent minimal exposure to actual commodity price risk with only moderate sensitivity to most economic shifts.  Further, MLP distributions have grown over time, thereby providing investors with an inflation hedge.

It’s worth noting that, like any investment, there are risks.  For starters, investments concentrated in one economic sector, such as energy, experience greater volatility than more broadly based investments.  The standard deviation (a measure of volatility) for this asset class is nearly 18% (January 2002 to December 2011).  Comparatively, the standard deviation for the S&P 500 is nearly 16% for the same period.  That said, MLP’s do offer diversification benefits, considering the correlation to the S&P 500 is 0.49.  As a refresher, correlations range from -1 (perfect negative correlation) to +1 (perfect positive correlation).  Investors can match asset classes with less than perfect positive correlation to reduce risk and increase return.

Exposure to MLP’s can be obtained by directly purchasing units on the exchanges, much like a stock.  However, that means investors will have to contend with and accept individual company risks.  Until recently, this was the only way to obtain exposure to this asset class.  Today, there are alternatives.  Perhaps a better option may be a more diversified basket of MLP’s by way of a mutual fund or ETF (for example the AMLP or EMLP exchange traded funds).

Taxation

Generally speaking, Master Limited Partnerships are publicly traded partnerships where “unit holders” receive distributions of the operating income of the partnerships.  Partnerships are an alternative to a corporation. Unlike investments with a corporation, distributions paid to unit holders are considered return of capital rather than the traditional ordinary income generated by corporations.  By comparison, corporations pay their after tax earnings to shareholders in the form of dividends.

MLP’s are considered tax-advantaged entities that “pass-through” distributions to owners. They are called “pass through securities” because they are not taxed at the corporate level, but instead pass the income on to the unit-holders who pay the taxes. However, investors should be made aware that MLP’s distribute K-1’s (rather than 1099’s) for tax purposes, which may introduce some level of annoyance for you and your CPA (unless the MLP’s are held in an open-ended mutual fund or ETF structure).

In closing, if you are looking to add another “feather in your cap”, MLP’s may be worth a look.  In a world of increasing interconnectedness, the inclusion of non-correlated assets in a portfolio can help investors dampen risk while enhancing returns.  As global demands for energy continue to increase, MLP’s may provide investors opportunities for both growth and income.

 

Disclaimer:  this article is for educational purposes only and should not be construed as individual investment advice.  Any investment vehicles mentioned in this article are not intended to be endorsements. Consult with your financial professional and tax advisor regarding your specific situation.