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An Exchange-Traded Note for Low-Cost Exposure to MLPs

MLPs have fallen out of favor this year amid lower commodity prices, currency concerns, and interest-rate fears. This ETN offers broad exposure to the asset class.

Robert Goldsborough, 07/30/2015

Holders of exchange-traded products devoted to energy-oriented master limited partnerships felt plenty of pain in the first half of 2015. First, it was lower commodity prices and some tough quarter-over-quarter comparisons. Then the space was walloped by concerns about foreign currency and a likely increase in interest rates.

While MLP returns have not been pretty thus far this year, they have served as an important (if painful) reminder that MLP ETPs are not immune to energy-price volatility. There’s no question that they are more insulated than broad energy funds when it comes to energy-price movements, but they do end up feeling some pain. About one fourth of industry cash flows are commodity-sensitive, so as oil prices declined relative to natural gas prices, gas processing margins contracted, weighing heavily on the cash flows of MLPs that have non-fee-based gas processing businesses.

Over the longer-term, investors should take comfort in several important dynamics. First, commodity price volatility shouldn't mean long-term pain for MLPs. The reason is that a prolonged slump of crude oil and natural gas prices should stimulate demand, which ultimately would be good for MLPs. Also, MLPs create value by building new assets. So as long as lower oil prices don’t hinder project development, MLPs' growth prospects should not be affected. As for interest rates, few expect rates to rise dramatically in the coming months, which in theory should help to keep MLPs' costs of capital low and their value proposition appealing, particularly as they should continue to generate relatively high levels of income while also having a low correlation to other income-focused asset classes.

For access to the performance of a basket of MLPs, investors can consider JPMorgan Alerian MLP ETN AMJ. AMJ is an exchange-traded note, which means that it is an unsecured debt instrument that is structured to track the return of an underlying index, less fees. Unlike an exchange-traded fund, an ETN holds none of the underlying assets in the benchmark that it tracks. ETN investors should take note of their structure and taxes. Because ETNs are debt instruments, their investors run the risk of losing their entire investment if the issuer--in this case, JPMorgan Chase JPM--goes bankrupt. While the likelihood of bankruptcy is low, it's not zero. With respect to taxes, MLP unitholders normally receive complicated K-1 forms, which are notorious for arriving at investors' homes late in tax season. Because AMJ does not hold the underlying MLPs and instead perfectly replicates the performance of an index containing such securities, AMJ issues investors a much simpler, single 1099 form during tax season--a 1099 form typically arrives to investors' homes far earlier in tax season and is far less complicated. At the same time, because AMJ is an ETN, its distributions are taxed as ordinary income, whereas most distributions from individual MLPs are tax-deferred.

In mid-2012, J.P. Morgan capped creations of new shares in AMJ, likely because of the size of the bank's hedging costs. By far the largest ETN at $4.6 billion in assets, AMJ now functions in effect as a closed-end product. Lacking a process to create new shares, AMJ saw supply and demand become unbalanced, and its shares traded at premiums during much of 2013. However, its bid-ask spread has been much tighter since that time. Should AMJ trade at a premium going forward, new investors are better off considering similar MLP-oriented ETPs.

Because MLPs charge fees based on volume of energy products transported and not on unstable commodity prices, MLPs are less volatile than the broader the energy sector. For example, over the past five years, AMJ has had a standard deviation of 14.8%, while a large- and mid-cap energy ETF, Energy Select Sector SPDR XLE, posted a volatility of return of 19.7%.

Fundamental View
United States energy production continues its growth trajectory. Production drives MLP dividends, and as production grows, greater volumes flow through pipelines and MLPs pay higher dividends to unitholders. Looking ahead, the outlook for U.S. energy production is positive. The U.S. Energy Information Administration expects natural gas production to grow at least until 2020. Meanwhile, oil extraction advancements have significantly boosted U.S. production, altering the global oil supply picture.

Over the longer term, prospects for the energy MLP industry are generally favorable. While lower energy prices may slow project development and may limit energy MLPs' ability to keep their project backlogs full, the vast majority of MLPs' cash flows are linked to long-term, fee-based contracts, supporting relatively stable cash flows despite market tumult.

MLPs benefit from federal rules that require the rigorous vetting of new energy projects. That means that only the most viable pipelines tend to get built, and many of the ones that are built become local monopolies. Because their assets are difficult to replicate, most MLPs are awarded wide Morningstar Economic Moat Ratings.

Interest rates pose a meaningful risk for MLPs. Low interest rates have enabled cheap debt financing for MLPs, which pass along almost all of their taxable income to unitholders. Higher interest rates would mean a greater cost of capital and potentially lower distributions to unitholders. Higher rates also would make MLPs less attractive to investors from an income standpoint, although MLPs aren't nearly as rate-sensitive as some other asset classes like REITs and high-yield bonds.

A corporate restructuring has changed the index that MLP-oriented ETNs track. In a $44 billion deal completed in November 2014, Kinder Morgan Inc. KMI, long a "C corporation" holding company (and not an MLP), consolidated wide-moat energy MLP affiliates Kinder Morgan Energy Partners, Kinder Morgan Management, and El Paso Pipeline Partners into a single publicly traded corporation that is the largest energy midstream firm. This consolidation benefits investors, as it increases Kinder Morgan Inc.'s distribution growth rate. MLP investors reacted favorably to the news, which triggered a special index rebalance for the two principal Alerian MLP indexes. With this transaction completed, index providers have elected to keep Kinder Morgan Inc. out of key MLP indexes, as Kinder Morgan Inc. is not an MLP. As a result, for better or worse, MLP-oriented ETPs do not reflect the performance of the nation's largest midstream energy firm. Prior to the deal, Kinder Morgan Energy Partners had made up 9%-9.5% of the two Alerian indexes, while El Paso Pipeline Partners had comprised another 2%-3% of the two indexes. (Kinder Morgan Management and Kinder Morgan Inc. had not been held in either index previously.) The deal did create a taxable event for unitholders in Kinder Morgan Energy Partners and El Paso Pipeline Partners but did not create a taxable event for investors in MLP ETFs.

Will the Kinder Morgan deal change underlying industry dynamics? Our equity analysts don't think so, given that its affiliates long have had deep existing connections to the Kinder Morgan parent. However, this consolidation will likely spark other similar corporate reorganizations, although not necessarily immediately.

Portfolio Construction
AMJ tracks the market-cap-weighted Alerian MLP Index, a float-adjusted benchmark comprising the 50 largest MLPs. In total, the index is aimed at capturing some 75% of the available market capitalization. The index rebalances quarterly, although special rebalancings can occur when triggered by corporate actions, such as mergers of index constituents. Investors who own actual MLPs receive the IRS' K-1 forms, which detail an MLP's taxable income. However, because AMJ is an ETN and thus a debt instrument, it owns no actual shares of the MLPs in the index that it tracks. So at tax time each year, AMJ investors receive 1099 forms and not K-1 statements, and distributions are taxed as interest income. As a result, holders of AMJ do not receive any of the long-term tax benefits that actual MLP investors enjoy.

Fees
AMJ charges 0.85% annually, which is in line with most competing exchange-traded MLP products. This ETN has a path-dependent fee structure that charges based on the volume-weighted average price of each MLP component in the Alerian MLP Index, which could make the actual cost deviate from 0.85%. All MLP ETNs employ a path-dependent fee structure.

Alternatives
The closest alternative to AMJ is UBS E-TRACS Alerian MLP Index ETN AMU, which tracks the same index. AMU's 0.80% expense ratio undercuts all of its competitors, which charge 0.85% or more. UBS launched AMU one month after AMJ said it would stop issuing new shares, but AMU remains small.

Several large ETPs focus solely on energy infrastructure MLPs, which are a subset of the MLP universe specializing in "midstream energy," or the gathering, processing, and pipeline transportation of energy commodities. As a practical matter, energy infrastructure ETPs' performance isn’t meaningfully different than pure energy MLP-themed ETPs. And while energy infrastructure MLP-themed ETPs generally have the same top 10 holdings as pure MLP-themed ETPs, energy infrastructure MLP ETPs track indexes that are far more concentrated. The largest MLP product, ALPS' Alerian MLP ETF AMLP, is an energy infrastructure MLP fund. In addition to being an ETF, AMLP is structured as a corporation. As a result, this ETF pays income tax at the fund level and then accounts for those tax liabilities in the net asset value. For investors, this practice allows potential downside protection, as some losses can be written off using deferred tax assets. AMLP has lagged its index by almost 8 percentage points annualized since its inception through the end of 2013, even though its expense ratio is 0.85%. This poor tracking stems from regulations barring open-end funds from holding more than 25% of their assets in MLPs, which is why AMLP structures itself as a corporation. The performance of AMLP and AMJ is 97% correlated over the past three years.

Another energy infrastructure MLP ETN, UBS ETRACS Alerian MLP Infrastructure ETNMLPI, has grown significantly since AMJ stopped issuing new shares. Although MLPI tracks a more concentrated index of 25 infrastructure MLPs compared with AMJ's 50, the two ETNs' performance is closely correlated, to the tune of 96% over the past three years. MLPI charges 0.85%.

Still another energy infrastructure MLP ETN worth taking a look at is Credit Suisse X-Links Cushing MLP Infrastructure ETN MLPN (0.85%), which tracks an equal-weighted index of MLPs. That means MLPN's index has a greater emphasis on smaller-cap MLPs and a smaller emphasis on larger-cap ones. MLPN courts greater volatility, and fewer of the MLPs in its index have economic moats than those found in market-cap-weighted indexes.

 

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

Robert Goldsborough is an ETF Analyst at Morningstar.
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