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Tap Into Unloved MLPs Using Exchange-Traded Notes

Christine Benz
Robert Goldsborough

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. After soaring for the better part of this decade, master limited partnerships have recently come back down to earth. Joining me to discuss this sector and to share some potential fund ideas is Robert Goldsborough--he is an analyst with Morningstar.

Bob, thank you so much for being here.

Robert Goldsborough: Thank you, Christine.

Benz: Bob, at a very basic level, what are MLPs--master limited partnerships--and how are they different from owning dividend-paying common stocks?

Goldsborough: Master limited partnerships are companies that are set up to own and manage energy infrastructure assets, such as oil and gas pipelines and oil and gas storage facilities. They are a relatively new asset class, and they generate very high yields as well. But the way they are structured is that because they are partnerships they pay out almost all of their income to their unitholders. As a result, they have generated very high dividends--much higher than most dividend stocks.

Benz: Recently, we have seen the MLP sector come down quite a bit. I think it's interesting because, prior to this happening, people had thought because MLPs are just transporting oil and gas that they would be relatively impervious to commodity-price declines. In reality, it hasn't played out that way.

Goldsborough: It sure hasn't. This year has been a really rough year. Really, ever since energy prices began declining, these MLPs have really been hurt. That's been for a couple of reasons. One has been clearly that the commodity-price decline has hurt investor sentiment, but it also has hurt their economics. About one fourth of MLPs' cash flows are directly linked to commodity prices. So, they turned out to be not as impervious as everyone thought. On top of that, MLP investors have been spooked by the potential for rising interest rates and how that would impact MLPs. It flows through in a couple of different ways. One involves the fact that debt-financing costs would go up for new pipeline projects. But then, secondly, MLP yields would be at risk because their cost of capital would go up; that, in turn, might make an MLP look, on a relative basis, less appealing versus some other income vehicles.

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Benz: In contrast with a lot of other parts of the market where you can buy a traditional open-end mutual fund--maybe even an actively managed fund--that's not really how you invest in MLPs. Most of the assets in baskets of MLPs are in exchange-traded products--either exchange-traded funds or notes. I'd like to discuss some of the bigger ones. Let's start with the Alerian MLP ETF (AMLP). That's the biggest ETF tracking the MLP sector, correct?

Goldsborough: It is. That's right. It's issued by ALPS and has the ticker symbol AMLP. It's very large, and it has a very, very high expense ratio because of its structure. It is an ETF, but it's not a 1940 Act fund. Instead, it's actually structured as what's called a C-corporation. Unfortunately, from a tax standpoint, these C-corporations have certain deferred-tax issues that end up flowing through to an investor's actual cost at the expense-ratio level. As a result, the ordinary investor can expect to pay more than 5% a year in investor fee on AMLP. It's unfortunate because it's a very well-run product; it tracks its index as well as could be expected. But unfortunately, this high fee makes it a fairly unappealing option.

Benz: We often talk about the importance of fees. It sounds like that really would limit our recommendation of any such product because it's just too big of a headwind for the product to overcome.

Goldsborough: Unfortunately, yes.

Benz: Another product that tracks the MLP space is JPMorgan Alerian MLP Index ETN (AMJ). Before we get into the specifics of that product, can you just quickly talk about the difference between an ETN--an exchange-traded note--and an exchange-traded fund?

Goldsborough: An exchange-traded note, or an ETN, is really a debt security issued by an investment bank. In the way they are structured, they perfectly replicate their index. There is no what's called "tracking error," where you need to worry about differences between the index and the underlying security. There is a perfect replication and, as a result, the performance tracks the index perfectly.

Benz: Minus the expense ratio.

Goldsborough: Less the expense ratio, yes. So, an exchange-traded note is, we think, a really good way to invest in the MLP space at the fund level because of some of these tax issues that we were talking about with the Alerian MLP ETF. There is a risk behind an ETN, which is that it's a debt security of an issuing bank. Should that bank go under, investors might lose their entire investment. But this is issued by J.P. Morgan, which is a really robust bank, and I think most people think that J.P. Morgan is going to be around for a while.

AMJ is the ticker of this JPMorgan Alerian MLP ETN. It costs 85 basis points, which is a very attractive expense ratio, and it tracks a very well-regarded, popular index. Probably the one concern that I think we have with JPMorgan Alerian MLP ETN is that, since 2012, the ETN has been closed to what are called "new creations," which is the issuance of new shares. That, in and of itself, wouldn't have any impact on existing shareholders or on the secondary market--on investors going out and buying shares in it--except for the fact that, beginning in 2013, the ETN's net asset value began to trade away from the share price. So, when that happens, the ETN is now behaving more like a closed-end fund. Since 2013, however, AMJ has traded much more closely. The net asset value and share price have been very close. So, I think AMJ is a terrific option for investors looking for exposure to a basket of MLPs. I just think that an investor should watch AMJ closely, and if net asset value and the share price diverge, at that point I think an investor would want to consider other products.

Benz: There is another product--an exchange-traded note--that tracks the same index. Let's talk about that one. It's actually a little bit cheaper, but it is smaller. I don't know whether that's a consideration or a concern in any way, but let's talk about that fund.

Goldsborough: Sure. That one is issued by UBS, the investment bank. It's called UBS ETRACS Alerian MLP ETN (AMU) and, indeed, AMU tracks the exact same index as AMJ. As a result, an investor could expect the exact same performance from that product, minus fees, that one would get from AMJ. It is a little cheaper--it's 80 basis points. From an investor standpoint, I think it's large enough and has sufficient liquidity to meet an investor's needs. And because it's much smaller than AMJ, investors don't at this time need to worry about capping the ETN to new creations.

Benz: Last question for you, Bob: If I'm looking at this sector and I think it's potentially undervalued, should I just venture into some of the individual MLPs? Is there any advantage to doing that? I guess if I select well, that's the big advantage. But let's discuss the pros and cons of going for the single security versus going for a basket of MLPs like some of the ETNs we just talked about.

Goldsborough: Certainly, an investor who does his or her homework and has a fair understanding of a security's value could, I think, do very well with individual stock-picking. The issue, however, with owning an individual MLP comes at tax time. For the unitholders, which is what investors of MLPs are called, unfortunately they must file a K-1 form with the IRS. Those are notorious for arriving very late during tax season at investors' homes. So, if an investor would like to file his or her tax form early in tax season, the late arrival of the K-1 form can complicate that. By comparison, the ETFs and ETNs generally issue 1099 forms where they do all the tax work for you. It's much simpler. You get the IRS 1099 form much sooner in tax season.

Benz: Bob, thank you so much for being here to share your overview of a sector that has been pretty unloved lately but may provide some opportunities for investors going forward. Thanks a lot.

Goldsborough: Christine, thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.