As oil collapsed over 65% during the first quarter, the Master Limited Partnership (”MLP”) sector imploded as well. Many investors gain MLP exposure through closed-end funds, exchange-traded funds (“ETFs”), exchange traded notes (“ETNs“) or more traditional open-end mutual funds (I am grossly simplifying the discussion, since there are important nuances for mutual funds only investing in MLPs).
Traditionally, many investors seek out MLPs to capture the attractive yields, which average about 7% over the long-term according to Alerian, a leading MLP index provider. In addition, those dividends can be quite attractive on an after tax basis, if a large-portion of those dividends get classified as a return of principle (I won’t get into the weeds on taxation).
The largest fund is the $3.6 billion Alerian MLP ETF (”AMLP”), which offers exposure to the Alerian MLP Infrastructure Index. This index contains MLPs that that earn the majority of their cash flow from midstream activities including the transportation, storage, and processing of energy commodities. The first quarter returns were abysmal as the Alerian MLP ETF dropped 58.3% and has amazingly lost 20.6% per annum over the last five years. The returns on closed-end funds were even worse, dropping 72.4%, as the leverage embedded in those funds exacerbated the returns. Interestingly enough, the average fund in the Morningstar Energy LP category “only” fell 51%. Which brings me to my main point, some funds performed substantially better that the Alerian MLP Infrastructure Index because those funds don’t exclusively invest in MLPs. The energy infrastructure sector also contains companies structured as traditional corporations (also known as Pipeline C-corps), not as a limited partnership, and still derive much of their cash flow from energy midstream activity.
The table below illustrates two funds that performed substantially better than the Alerian MLP Infrastructure Index. The returns are still negative, but less than the market and more diversified. I picked these two funds because I know they pursue a broader mandate and don’t invest 100% in MLPs. Other excellent choices fund choices exist in this sector for investors to choose from. (I am not endorsing or making an investment recommendation for either of these two funds. The reader needs to perform their own research to determine the suitability for their individual circumstances).
Other issues to consider are the concentration in the sector and the underlying MLP trading volume. The number of companies in the MLP universe has been shrinking and according to Alerian, the number of constituents in the Alerian MLP Index has dropped by approximately 36% since 2015, forcing an enormous pool of capital into fewer names. In addition, the underlying liquidity has eroded. By my estimate, the AMLP ETF holds, on average, about six days of trading volume in each underlying MLP. When the aggregate assets of dedicated MLP funds are added to the mix, the liquidity issues become more problematic.
Unfortunately the more diversified funds offer yields much less than those funds invested exclusively in MLPs, but is the extra yield worth the potential permanent loss of capital? In my opinion, no.