MLPs, REITs, and the Search for Uncorrelated Returns
Should MLPs be added to your asset allocation?
ETF Specialist
Interest in publicly traded master limited partnerships has grown considerably in recent years. The number of energy and infrastructure MLPs has grown from about 17 to 75 in the past 15 years while the outstanding market capitalization has gone from $7 billion to $220 billion. Gaining access to this growing market through diversified products was limited to a handful of closed-end funds, but in the past two years, five mutual funds and eight exchange-traded products have launched to cover the space. The growing interest in MLPs has been driven by changes in regulation, the search for higher yields in a low interest-rate environment, and disappointment in the diversification benefits of traditional asset classes in the wake of the financial crisis. MLPs offer tax advantages, attractive yields, and low correlations to equities. With the additional tax complexity of MLPs, more due diligence than normal is required. But those willing to do the work will be rewarded.
A Better Mousetrap?
Modern Portfolio Theory is based on the notion that you can get better risk-adjusted returns by diversifying between uncorrelated assets. But the advantage may be diminished as the light gets shone on these smaller and undiscovered assets and they become widely followed, indexed, or even marketed within an ETF. Thus, the act of investing based on past information can change the results that we get in the future. Call it the Heisenberg Uncertainty Principle of investing.
Take REITs, for example. Between 1996 and 2006, the correlation between REITs and the S&P 500 was only 35%. The first REIT was added to the S&P 500 in 2001, and several followed throughout the decade. At the same time, a number of studies came out touting the diversification benefits of REITs. Over the past three years, the correlation spiked to 85%. The previously low correlation resulted in part from the fact that the performance of REITs was unrelated to the performance of large-cap and technology stocks that dominated the performance of the S&P 500 during that period. While the recent rise in correlation has been observed in a number of asset classes because of increasing global macroeconomic risks, there is also something to be said of the effect of indexing. As more assets have flowed into passive index funds and as REITs have increasingly become part of those indexes, the correlation has increased. James Xiong of Ibbotson Associates labels this phenomena trading commonality, and his research suggests that it has reduced the diversification benefit from correlation.
1996-2010 Compound Annual Return % Volatility % Sharpe Ratio Russell 1000 TR USD 7 17 0.29 Russell 2000 TR USD 8 21 0.31 MSCI EAFE GR USD 5 17 0.19 MSCI EM GR USD 8 25 0.30 BarCap US Agg Bond TR USD 6 4 0.68 S&P GSCI TR 5 24 0.17 DJ US Real Estate TR USD 10 22 0.38 Alerian MLP TR USD 17 16 0.84 data from 2/1996-2/2011Monthly Return Correlation Alerian MLP DJ US Real Estate Russell 1000 Russell 1000 0.36 0.59 1.00 Russell 2000 0.36 0.66 0.83 BarCap US Agg Bond 0.05 0.11 0 S&P GSCI Energy 0.22 0.12 0.18 Morningstar Sec/Utilities 0.39 0.42 0.46 BarCap HY Utility TR USD 0.48 0.42 0.45 Morningstar Sec/Financial Svcs 0.32 0.71 0.83 data from 2/1996-2/2011
To analyze the benefits of an asset allocation to REITs and MLPs, we started with a base portfolio invested in large- and small-cap U.S. stocks, international developed- and emerging-markets stocks, as well as bonds and commodities. The portfolio was rebalanced annually to its initial weights. Between 1996 and 2006, the portfolio returned a compound annualized return of 8.9%. If we add a 10% allocation to REITs (reducing the allocation to the other assets but keeping their proportions the same), the return improves to 9.7%. However, between 2006 and 2011, the portfolio with the 10% REIT allocation returned 3.5% compared with 4.0% for the no-REIT portfolio. While risk decreased in the earlier period, it increased in the later period. The benefits of REITs did not hold up as promised.
If Not REITs, How About MLPs?
Conducting the same experiment with MLPs showed a similar improvement between 1996 and 2006, with the portfolio return moving to 10.0% from 9.0%. But the most recent period also showed an improvement, to 5.0% from 4.0% as well as a reduction in risk in both periods.
But Will the Diversification Benefits Hold Up?
There are several reasons to expect that MLPs will keep their status as a portfolio diversifier. There is a large segment of the investment industry that will likely continue to avoid MLPs for tax reasons, and MLPs are not likely to be added to broad stock indexes. Investments in corporations are subject to double taxation--once at the corporate level and then again at the investor level. A special exemption in the tax code allows both REITs and MLPs to avoid the taxation at the company level but restricts operations to certain qualifying activities. At the investor level, taxation of REITs and common stocks is similar as investors will receive a 1099 for their dividend income. But MLPs are taxed as pass-through entities, meaning investors are taxed based on their share of the MLP's deductions and income. Because of an allowance for depreciation, a large portion of an MLP's distribution is treated as a return of capital, which lowers the investor's cost basis in the MLP. This lower cost basis may also be stepped up upon death, making MLPs a valuable estate-tax-planning instrument. Instead of a 1099, investors receive a K-1 reflecting their interest in the partnership. However, investors are required to file a state income tax return in every state in which the MLP does business. Enterprise Products Partners L.P.EPD does business in 36 states. Holding an MLP in a tax-deferred account can lead to other tax complications, as highlighted in this article by Christine Benz.
These tax issues make MLPs less desirable in a broad index. Since indexes are meant to be investable, including MLPs in an equity index would make it less appealing to many investors. The Standard & Poor's 500 Index is designed to include only common equity, REITs (other than mortgage-REITs), and certain business-development companies. MLPs are technically not common equity but rather publicly traded partnership interests. Additionally, limited partners in MLPs do not have the same corporate governance or voting rights as stockholders in a corporation. While the 2004 American Jobs Creation Act increased the percentage of MLPs that mutual funds can hold, mutual funds still tend to avoid MLPs. For example, just 6% of the largest MLP, Enterprise Products Partners (EPD) is owned by mutual funds compared with 29% for ExxonMobil (XOM) and 24% for Citigroup (C).
A shift toward passive ownership of MLPs within asset-allocation plans is also unlikely. MLPs make up just a small segment of the market. The investable market cap of all 50 MLPs in the Alerian MLP Index is only about $146 billion. That compares with $14 trillion in all of the companies in the Russell 1000 Index and another $1 trillion in Russell 2000 stocks. On a market-cap-weighted basis, an allocation to MLPs would make up less than 1% of the size of the Russell 3000. After factoring in transaction costs, an allocation this small does not make sense for most investors. But just because the CalPers of the world cannot allocate 5% of their portfolio to MLPs doesn't mean that a nimble individual investor cannot.
What About the Sustainability of the Returns?
MLPs earned a fantastic 17% compound average annualized total return over the past 15 years, beating the 7% for the Russell 1000 with less volatility along the way. While it would be naive to expect that kind of performance to continue indefinitely, there are reasons to expect above-average returns in the future. MLPs operate in a near-monopoly position with high barriers to entry; for example, once a pipeline is constructed, the marginal cost of distribution is very low and it would not be very economical to build a competing pipeline to serve the same market. Many MLPs generate stable cash flows, essentially operating like a toll road and collecting fee revenue for the right to use a pipeline rather than being directly tied to the price of a commodity. While there is some exposure to commodity prices for certain MLPs, the correlation to commodities over the past 15 years was only 0.25. This is similar to the level of correlation between commodities and utilities stocks and much less than that experienced by energy stocks. Additionally, a large number of MLPs operate interstate pipelines where rates are regulated by the Federal Energy Regulatory Commission. Recently, FERC raised the rate adjustment that pipelines are able to charge to the producer price index plus 2.6%. Perhaps the strongest argument for sustained excess returns to MLPs is based on their tax structure. Avoiding double taxation allows MLPs to maintain a consistently higher return on capital.
But these higher returns are not guaranteed and there are a number of risks to their sustainability. Changes in tax law or regulation pose a threat. Prior to 2003, the rate adjustment allowed by FERC was less favorable at only the PPI minus 1%. Because MLPs pay out such a large percentage of their earnings as distributions, potential for book value growth is limited. MLPs can be expected to behave like fixed-income securities with prices sensitive to changes in interest rates. The average yield spread over 10-year Treasury bonds has averaged 270 basis points, about where it is today. But with interest rates expected to rise, MLPs may not be as attractive of an opportunity going forward. Additionally, the aggregate size of the investable market is only about $140 billion. It is entirely possible that fund flows into the new investment products could lead to a bubble in MLP prices and lower subsequent returns.
MLPs Direct or Through a Fund?
How to best own MLPs depends on your individual situation and preference. The most efficient way to capture as much of the tax benefit as possible is to own MLPs directly, but this also makes tax reporting more complicated and exposes smaller investors to idiosyncratic risks and higher transactions costs. Owning MLPs directly within a tax-deferred account such as a 401(k) can generate unrelated business taxable income, which requires the account to pay taxes. Owning them within a fund allows for the benefits of diversification and eliminates the threat of generating UBTI and the nuisance of filing multiple K-1s. However, this convenience comes at the cost of a loss in tax efficiency. Funds that invest more than 25% of their assets in MLPs lose their status as a regulated investment company for tax purposes, which means they are no longer exempt from taxes at the entity level, thus subjecting some of the distributions to double taxation.
Within the exchange-traded product space, two vehicles have each raised more than $1 billion in assets in a short period of time. ALPS Alerian MLP ETF (AMLP) invests in 25 infrastructure MLPs involved in transportation, storage, and processing of energy commodities, while JPMorgan Alerian MLP Index ETN (AMJ) holds a wider set of 50 MLPs, which includes infrastructure MLPs as well as those with assets in shipping, production, and retail delivery. Both AMLP and AMJ charge a 0.85% expense ratio, and, while they track slightly different indexes, the MLPs in AMLP comprise 72% of the weight in AMJ.
My colleague Paul Justice highlighted the difference between MLP investing using an ETN or ETF structure here.
The biggest difference between these two funds is in the tax treatment of their different structures. Because an ETN is essentially a debt instrument, its distributions are taxed like interest payments, so the preferential tax treatment of MLP distributions is lost. This is not an issue for an investor holding the ETN in a tax-deferred account, but an investor who prefers tax-advantaged distributions or who is expecting the bulk of future returns to come from distributions would likely prefer to hold MLPs within an ETF structure. However, ETFs holding MLPs must accrue a deferred tax liability from tax-deferred distributions and when MLP prices appreciate, which can be unwound if the prices fall. This accrued liability makes the ETF price less volatile, participating less on both the upside and downside.
On a pretax basis, the ETN has a better track record. Since its launch last August, the index is up 15.6% of which 10.5% was from price appreciation. AMJ is up 16.0% while AMLP is up just 9.0%. But these numbers do not reflect the aftertax return, which will depend on an individual's tax situation and the amount of the distribution. Because MLPs typically have a large amount of depreciation that is passed on to the owner, MLP distributions contain a large return of capital. Because the ETN is a note and not a portfolio of MLPs, the distribution is taxed at the investor's marginal tax rate. However, the ETF actually owns the MLPs, so the return of capital portion of the distribution will be passed along to the investor. The remainder of the distribution will be taxed first at the corporate level and then again at the 15% individual dividend level. All in, the distribution on the ETF will be taxed at a lower rate than the distribution on the ETN, but this still probably would not be large enough of a difference to close the performance gap between the ETN and ETF over the past eight months. Going forward, we do not expect such a large price appreciation to continue, so distributions will constitute a larger component of total return. Morningstar's MLP analyst, Jason Stevens, currently sees most MLPs as slightly over valued and sees distribution growth slowing to 4-6% a year from 6-8% a year in the recent past.
The addition of MLPs will improve any asset-allocation back-test. But when an asset class has experienced such strong performance and gained investor attention, it is unlikely that those improvements will last indefinitely, as was the case with REITs. That said, the unique tax considerations and competitive position of MLPs may continue to yield above-average returns.
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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.