Introduction to MLPS
Diversification, high income, tax efficiency, low correlation to traditional asset classes; these four elements would seem to be the pillar of every well designed investment vehicle. Master Limited Partnerships (MLP) have delivered just that for the last decade. But what is exactly an MLP? They are publicly traded, limited partnerships which own and operate gas and oil pipelines, storage terminals and refineries. They are structured like partnerships to take advantage of favorable taxation and to create income focused investment vehicles.
MLPs have over the years concentrated in sectors related to energy but unlike their earlier versions of the 1980s which were structured solely for the purpose of exploiting tax loopholes in the oil and drilling area, these new partnerships have become efficient and dynamic utilities. They have acquired cheap assets with predictable cash-flows like pipelines and terminals and became very good at operating them.
These investment vehicles retain only a mild correlation to the price of oil and gas since they care mainly for its transportation. However, as the economy grows and demand for energy grows with it, the profits of the MLPs increase accordingly. MLPs also offer protection against inflation in two ways: via their portfolio of real assets and via “inflation-plus pricing,” or in other words their ability to price their services and products at a premium of the PPI rate.
Energy Infrastructure MLPs provide a business model similar to Utilities and Real Estate Investment Trusts. They own and operate real assets and benefit from fairly inelastic long term energy demand growth. According to the Interstate Natural Gas Association of America, the need to restructure the shifting domestic gas landscape will require, over the next twenty years, roughly $200 billion in capital expenditures. Another source of growth is indicated by analysts in the trend of acquisitions by MLPs of midstream assets. It is estimated that approximately $200 billion of such assets are housed at private and public corporate structures and they could find their way into MLPs’ portfolios (source: Alerian).
The potential benefits of investing in a portfolio of MLPs vary from:
- Asset Growth
- Visibility of Cash Flows
- Income Growth
- Inflation Hedging
- Tax Advantages
- Historical Total Return
An MLP is a Partnership and not a corporation; for this reason it avoids taxation at the entity level and all income flows proportionally to the partners. Partners are defined as unit-holders and for tax purposes instead of receiving 1099 forms they receive K-1 Schedules.
MLPs make cash distributions (not dividends) and typically at least 70% is considered tax deferred return of capital which reduces the unit-holder’s (partner) cost basis in the investment. As long as the unit-holder basis remains above zero, taxes are deferred until the sale of the MLP. When the cost basis hits zero, distributions are then taxed at a mix of capital gains rates and personal income tax rate.
MLPs can provide flexibility in the process of estate planning; if the units are inherited, after the passing of the original unit-holder, the basis is increased to fair market value on the date of death and prior distributions are not taxed (source: Alerian.).
**This summary is for general information purposes only; it is based on current legislation; it does not take into consideration specific investor's situations. Please consult with your CPA.
Traditional Valuation Metrics
MLPs are usually valued slightly differently than traditional stocks; multiples of Distributable Cash Flows are usually more relevant than traditional P/E ratios. Our approach weighs highly the Yield Spread over the 10 Year US Treasury and over other income vehicles such as BBB bonds and REITS.
The Alerian MLP Index is comprised of 50 most prominent energy MLPs. The Index is calculated using a float-adjusted, capitalization-weighted methodology and it is in real time.
In the last ten years (2015-2015) the index has increased by 9% annualized with a Sharpe ratio slightly superior to the S&P 500 index. Since 1995 the average yield has been roughly 7.8%. In the decade from 2002 to 2011 the index showed a modest 0.5 correlation to the S&P500.
Our Investment Approach
Our strategy revolves around the components of the Alerian Index. Our average number of holdings can fluctuate from as low as 15 to as high as 40 depending on macro and micro analysis. Our approach is based on a core-satellite model, where our core exposure is implemented via investments in the Majors and our satellite is comprised of specific sub-sectors concentrated exposure.
Active Risk Management
We also implement an option overlay to tactically respond to overbought/oversold situations. Total exposure is also increased/decreased based on macro views and valuation metrics.
** Our investment approach may not replicate the same returns produced by the index.