MLPs: ‘A Place in Every Portfolio’

Try finding a young asset class that financial advisors are more excited about than the high-yielding master limited partnership.

“My clients own two kinds of investments: those we’re married to and those we date. We’re married to energy MLPs,” says Leonard Weiss, senior vice president of investments with the wealth-management group of Raymond James & Associates in Farmington Hills, Mich., in an interview. He’s been investing in MLPs for more than a decade.

Indeed, at Morgan Stanley, MLPs have been one of the firm’s top 10 investment ideas for the last few years, according to financial advisor Michael Bollinger, managing director, Morgan Stanley Private Wealth Management in Houston.

MLPs—many of which are companies that provide pipeline transport and storage for oil and natural gas—are conservative investments that offer consistent, stable income through distributions (i.e., dividends) that have the additional benefit of growth. While equities require earnings for improvement, MLPs are bolstered by increasing distributions. Moreover, MLPs offer tax advantages not available with common stock.

“What differentiates MLPs is their ability to continue to increase distributions over a longer, five-to-10-year time horizon. And that can overcome any correlation to equities, interest rates and commodities, because the fee-based pipelines—the piece of the marketplace that we focus on—are very consistent. It’s similar to owning a private company that pays out cash flow,” says Ethan Bellamy, managing director, Robert W. Baird Co., in Denver, in an interview.

There are two components to MLPs’ total returns. “You get a return of capital, which makes the tax deferral possible [until you sell the MLP], and you also get distribution growth,” explains Phil Blancato, CEO and chief investment officer of Ladenburg Thalmann Asset Management in New York, in an interview. “As more gas or oil is put through the pipeline, the greater distribution you’ll get.”

There are several options when investing in MLPs: buying shares of individual partnerships or turning to open-end mutual funds, closed-end funds, exchange-traded funds and exchange-traded notes. Investing in MLPs, many of which focus on the midstream section of the energy chain, is a significant way to participate in America’s energy revolution and therefore the country’s continuing effort to become energy independent, experts say.

Energy Revolution

“What is occurring in energy in the U.S. is our fourth revolution,” Blancato notes. “First, there was the Agricultural Revolution, then the Industrial and Technological Revolutions. The fourth one focuses on the energy space. Investing with MLPs is a way to capture part of the revolution without having direct commodity-price exposure to oil and natural gas.”

“It’s a sunrise-sunset business model,” shares Weiss, who adds that 45% of his clients own MLPs. “That is, natural gas, oil, petrochemicals are [always] moving through some pipeline, somewhere.”

Now is a good time to invest in MLPs, analysts and advisors agree. In fact, “It’s a perfect time. They offer liquid exposure to the energy boom that’s happening. We’re recommending that generally all our clients invest in them,” says Ashley Lannquist, a senior analyst of investment research at New York-based Segal Rogerscasey, in an interview.

Advisors concur that MLPs are appropriate for most clients, not only those in the high-net-worth category, since the asset class is a great diversification tool. For smaller portfolios, ETFs or ETNs may be the best way to go, some suggest.

“The market tends to value MLPs higher than the same businesses that are in a corporate structure. Two utilities recently formed MLPs, and each one jumped 10%. They’re the same assets but in a different structure,” says Andy Pusateri, a senior utilities analyst with Edward Jones in St. Louis, in an interview.

MLPs are ideal for retirement planning, and indeed many advisors use them in this way to derive needed stable, consistent income. “For a taxable account in a retirement portfolio, most investors can have a 2%-5% allocation in MLPs to help enhance yield—especially now in this yield-starved environment,” says Bollinger.

About 10 years ago, he rebalanced client portfolios by replacing portions of both equities and fixed income with MLPs. For many advisors, MLPs have replaced high-yield bonds, fixed-rate preferred stocks and Treasury bonds.

MLP Developments

Some new MLPs are those that occur in the downstream section of the energy chain. These non-traditional, or unconventional, MLPs are tied to cyclical or seasonal assets, such as refineries and nitrogen fertilizer.

There also are non-traditional MLPs launched recently that offer variable-rate distributions. They tend to have a more volatile income stream than traditional MLPs, which generally pay according to a set structure. “The variable-distribution MLP is a trend that has been solidly in place for the last couple of years and is likely to continue,” says John Dowd, research analyst and portfolio manager at Boston-based Fidelity Investments, in an interview.

Variable-rate distributions, of course, may not meet some advisors’ criteria for the income stability their clients seek. But, as Weiss points out, “They are certainly a better play than the traditional C Corp. And with an MLP, you get a huge tax benefit.”

MLPs typically entail less volatility than the broader equity markets. And “they have a much better yield than equities,” notes Daniel Kern, president-CIO of Advisor Partners RIA in Walnut Creek, Calif. (near San Francisco). “MLPs are a great way to get alternative income. It’s a toll-road business model, where investing in pipelines and processing, the pipelines [and others] get paid a fee for usage. The MLPs have to distribute 90% of their income each year, so you get a claim on that revenue, a reasonably steady revenue base.”

MLPs comprise about 5-10% of the firm’s income portfolio, Kern notes. (He works primarily with investment advisors as a sub-advisor and also provides portfolio models to their high-net-worth clients).

One upstream MLP, Vanguard Resources, has moved to a monthly distribution. Vanguard’s chief business is the acquisition, production and development of oil and natural gas properties. So far, it’s the only MLP to have gone the monthly route, though others are considering it, Bellamy says: “It makes a lot of sense, because it will reduce volatility, which ultimately leads to better valuation.”

Investors in Vanguard Resources do not receive cumulatively higher distributions, because they occur monthly. “They just receive a smaller amount more frequently,” explains Lannquist.

Among the new, non-traditional MLPs are Hi-Crush Partners, which produces a specialized mineral used in hydraulic fracturing, and Lehigh Gas Partners and Susser Petroleum Partners, both wholesale fuel distributors. Blancato owns a few unconventional MLPs but notes, “You want to be selective, because they can have commodity sensitivity. However, this is one way to get commodity exposure, if that’s what you’re looking for.”

Steady Streams

Most advisors treat MLPs as an alternative-income strategy. “It’s an equity-yield hybrid, so it has equity-like characteristics and fixed-income characteristics in terms of yield,” says Bollinger, whose team manages $400 million in discretionary separate MLP accounts.

“The MLP has a low correlation to equities in the long term and a low correlation to fixed income, although MLPs can be correlated with anything for a short time. What differentiates them is that over a longer time horizon they have the ability to continue increasing their distributions to the unitholders,” he explains. “What you’re really buying is that distribution, that cash flow; so over time, the MLP will decouple from the broader market.”

MLPs are an emerging asset class with substantial room to grow. “The infrastructure spending on natural gas pipelines continues to go up every year in the range of $20 billion to $23 billion, so it’s only going to get better,” Blancato says. “Longer term, over the next five years, we expect a solid average rate of return of between 6% and 10% with very low correlation to the general market.”

Choosing individual MLPs is a critical process, since these partnerships differ greatly from one another. “I research and study them to determine where they fall in the category that we’d like to use,” says advisor Michael Flower, a partner with Financial Principles in Fairfield, N.J. (affiliated with Securities America). He then consults with his third-party money managers. “We’ll get their opinions of various MLPs and choose five to eight of them to put into our clients’ portfolios,” Flower adds.