Portfolio Fix: MLPs and Positive Returns

Savvy financial advisors know that these days of high market volatility and low interest rates demand strategic thinking to help clients reap fruitful investment returns. That’s why more and more FAs are relying on master limited partnerships to capture yield, reduce portfolio risk and hedge inflation.

There are 81 energy-related MLPs with a market capitalization totaling $350 billion. Since 2009, they are up close to 180% on a cumulative basis through March 2012. With their low correlation to the S&P 500 and broader market, MLPs are a four-star diversification tool.

“MLPs are getting more popular with advisors. There is still somewhat limited knowledge about them; but we’ve definitely seen interest grow in the last two years as investors have become a little wary of depending on price appreciation, and the market has had some gyrations,” says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, based in Arlington, Va., in an interview. “People are looking more for dividends and investments that generate income, and MLPs have fit the bill.”

With a current yield of 6%, plus forecasts of quarterly distribution (dividend) increases of 5% to 8%, and total return in the 10% to 15% range, MLPs are indeed appealing to many investors, financial experts say.

Advisors who use them —  and some began investing in MLPs back in the 1980s —  are enthusiastic about the impressive performance of this still-young, emerging asset class.

“We see MLPs as an alternative because they act differently from either fixed income or equities and should perform differently from the S&P 500,” says Phil Blancato, CEO and president of Ladenburg Thalmann Asset Management in New York, in an interview, who recently rebalanced $1 billion of managed portfolios to include about 2%-3% of MLPs.

A master limited partnership is indeed unlike any other type of investment product. “It’s not quite an equity. It’s not quite a bond. It’s a kind of equity-yield hybrid,” says Michael Bollinger, a managing director at Morgan Stanley Smith Barney private wealth management in Houston, in an interview. Bollinger uses MLPs with his ultra-high-net worth clientele whose $300 million in assets he and his team manage on a discretionary basis.

“MLPs have been the No. 1 performing asset class over 10 years,” says Bollinger, who started using MLPs 16 years ago. “Every client we’ve had in the strategy — since 2003 — has had a very good experience.” Nearly all of Bollinger’s clientele has a portion of their portfolios allocated to MLPs, he notes.

Most popular with advisors are the midstream MLPs — the “middle men” of the energy chain; the other two segments are upstream — exploration and production firms —  and downstream companies. “The E&Ps have to go and find more energy; the midstream companies don’t have to find energy — they just have to transport it,” Bollinger says.

Seeking appreciation as well as income for his base of corporate-executive and high-net-worth family clients, Richard Happle, senior vice president of investments with Raymond James & Associates in Tampa, Fla., invests client assets in upstream MLPs, of which there are only a handful. He likes LINN Energy (LINE) because of the company’s “high organic growth rate. And whenever they make an acquisition,” he says, in an interview, “they have the best hedging strategy of any MLP. We’re expecting a 35% total return from LINN.” (Happle’s investment experience with MLPs dates to 1984.)

Looking for diversity in energy exposure, some advisors invest in both propane and coal MLPs. Although coal is off right now, according to John Thorsen, a senior vice president of investments at Raymond James in Orlando, he expects to see some changes. “What we look for in situations like this,” he says, in an interview, “is a high income flow that seems sustainable so that people are basically getting paid to wait for things to get better. Thorsen and his team manage assets of $400 million.

But clients needn’t be in the high-net-worth bracket for MLPs to be suitable. “MLPs are for any investor who might be interested in income at any point in time,” notes Linda McDonald, vice president of hard assets with Segal Rogerscasey in Dublin, Ireland, in an interview.

At Edward Jones, MLPs are proving to be a sought-after product for clients. “Our clients are buying a lot of MLPs that have high yield. [That’s] because when the market goes down, interest rates are low, and their fixed income vehicles aren’t returning what they had in the past, they look for higher yield,” says Andy Pusateri, a senior utility analyst, based in St. Louis, Mo., in an interview.

“And in view of the financial crisis, along with the low-interest-rate environment that we’re in, people are searching not only for yield but for what they feel are safe investments,” Pusateri explains.

Clients are also looking for quality. “With fixed income, to get the high yield you do with MLPs, you need to dip down in quality and invest in junk bonds,” says Ashley Lannquist, investment research analyst with Segal Rogerscasey in Darien, Conn., in an interview.

On top of yield enhancement, MLPs can lessen portfolio volatility. “Some clients are still concerned about what happened in 2008 and don’t want to repeat that experience where everything dropped dramatically,” notes Thorsen, who has worked with MLP investments for 18 years. “They feel that when we do see another market correction, they want that income to give them some perceived cushion to the volatility.”

In May, concerned about volatility in oil pricing, Blancato replaced his natural-resources allocation — a fund representing about 5% in managed portfolios — with a direct investment in MLPs.

“That has proven to be very beneficial because with natural resources down as much as 14% year to date, the MLPs in that same sector are down roughly only 2.3% for the same period,” he says. “We thought: How can we remove the volatility? The MLPs are still in the energy sector but are [performing] as a dividend play rather than a total return play — and that’s very important.”

About 3% of portfolios owned by Blancato’s clients — which have an average account size $225,000 — are invested in MLPs; some higher-net-worth clients have a larger allocation.

Toll-Road Model

Blancato generally sticks to the midstream space, and he uses a simple analogy to explain to clients how pipeline companies get paid on the volumes they pass through their pipelines, which makes them less sensitive to commodity prices.

“An MLP,” he says, “is like the [N.J.] Garden State Parkway. Whether the price of gasoline in a car is $10 or $2 a gallon, the Garden State Parkway is indifferent. It will charge that car a toll every time it drives up or down. An MLP is basically a highway for natural gas and oil. We need to get it out of the ground and move it. So the MLP acts as a toll road for a commodity.” That explanation, he says, “works well with folks.”

MLPs are especially suitable for retirement portfolios. “They’re ideal because the dilemma today for income investors is that you can’t find attractive income without taking risks in either buying low-quality bonds or long-maturity bonds,” Happle says. “The advantage of MLPs, particularly for long-term investors, is that they are operating businesses that have a history of showing 6% distribution growth.”

In keeping with MLPs as retirement investments, many advisors are using them for inflation protection, since distribution increases have, over the years, outpaced the rate of inflation. “They are very much an inflation play,” Blancato says. “MLP contracts — and hence, revenues — are often tied to inflation indicators such as the Producers Price Index.”

As Pusateri points out in a recent MLP report: “A distribution that is increasing consistently every year can help offset the impact of inflation over time.”

For Thorsen, the type and extent of MLP investments depends chiefly on client risk tolerance. “For some of our more aggressive clients, an MLP that pays a solid income might be a more conservative portion of their portfolios. For some of the more conservative clients, it might be a more aggressive portion,” he shares.

This means “the people that need income are focusing on the higher income-paying vehicles and probably have a little higher percentage of their portfolios in MLPs, because right now they pay very nice income,” the advisor notes. “The folks that need no income and are more aggressive tend to have fewer MLPs. But the vast majority of my clients have some MLPs in their portfolios.”

One of Thorsen’s clients has done so well that he snagged a 30% compounded return investing in MLPs. “It was unusually good — not typical by any means,” the FA stresses. But his client, who had been focusing on MLPs since 2009, was “very concentrated in them and a real believer. He went against my suggestion to have more diversification. But so far, it’s worked great for him.”

Digging Deep

Bollinger employs a comprehensive screening process with a diversification theme. “First we look at geographies the company is playing in, because I want a diversification of that. I wouldn’t want anyone that’s concentrated, say, only on the Gulf Coast, because if a hurricane came and shut down transportation for a period, that would be a problem.”

The advisor also looks “at diversification across the value chain — crude oil MLPs, natural gas liquids, refined products. You start to build a value map for each company: What products do they play in? What geographies? What types of midstream? Are they gathering and processing systems or transportation systems moving the [energy] to a distribution point? If [the latter], do they have big intrastate systems transporting it, or do they have interstate pipes that connect across multiple states?”