By John Wasik
CHICAGO, Oct 12 (Reuters) - There aren’t too many places left to look for higher yields these days. The usual go-to baskets of high-yield and foreign bonds, REITs and high-dividend stocks are pretty well picked over.
One little-known vehicle to Main Street investors is Master Limited Partnerships (MLPs), publicly traded entities that own assets such as pipelines. Because of their unique structure, partnerships - which can be focused on energy holdings but may also invest in alternatives such as timber and real estate - generate a lot of cash that is distributed to limited partners. Spurred by global and domestic demand for oil, refined petroleum products and natural gas, for example, energy partnerships are constantly expanding. In the last few years, the oil and gas boom in North America has triggered robust growth.
Sparked by a combination of increased exploration and recovery, indexes that track energy MLPs have outperformed individual benchmarks representing utility companies, real estate investment trusts and the S&P 500 index over the past 10 years, according to the Alerian MLP Index. In the decade ending June 29, the MLP index returned 16.7 percent, compared to 5.3 percent for the S&P 500 Index and 10.7 percent for utility stocks.
In the past three years, MLPs have averaged 27 percent, compared to 16.4 percent for the S&P 500. The partnerships have mostly thrived because they have been linked to long-term energy trends and not the global banking, credit and real estate crisis.
For investors interested in diversification, MLPs offer returns that rarely follow in lockstep with big stocks. Since they more closely track energy prices and not stock-market sentiment, their correlation of 0.48 to the S&P 500 is relatively low, compared to 0.74 for real estate investment trusts, publicly traded companies that own properties. A perfect correlation is 1.00. The lower the correlation with common stocks, which tend to dominate most growth portfolios, the more protection you’ll obtain from equity sell-offs.
MLP holdings can be desirable if you’re heavily invested in common stocks, but there are other trade-offs that make them more volatile and costly.
Here are five tips for getting the most out of your investment:
1. For lower risk, don’t buy individual partnerships.
If you buy individual MLPs, you’re over-exposed to a single company. And they may be illiquid, meaning if you wanted to sell, you’d be unable to sell quickly. Since you become a partner when you buy them directly, you also have to deal with K-1 tax forms, which make your tax planning more complex and costly.
2. Look for ETFs that package MLPs.
A handful of exchange-traded, mutual and closed-end funds hold MLPs. If you hold partnerships through these vehicles, you’re relying upon managers to buy a mix of companies that affords you some diversification and reduces your single-company risk.
3. Get a broad mix of MLPs.
The ALPS Alerian MLP ETF holds big-name energy/pipeline partnerships like Kinder Morgan Energy and Enbridge Energy. The fund is yielding almost 6 percent.
For a more diversified mix, consider the First Trust North American Energy Infrastructure fund, which has 36 percent of its portfolio in long-established utility companies such as Dominion Resources and the Southern Company . The First Trust fund is up 5 percent for the three months through Sept. 29. It opened on June 19 of this year.
4. Understand the Risks.
While MLP funds offer you a variety of partnerships in one package, they are not risk-free. Their values are linked to commodity prices. If there are dips in oil or gas prices or oversupply issues, their prices will suffer. Since they tend to specialize in a small segment of the energy business, MLP funds are concentrated in a small number of companies that will often move in the same direction. They are not guaranteed in any way and their tax treatment can be complicated.
And if oil or natural gas prices collapse, you’ll be at even more risk; they are much more volatile than stocks or bonds. The five-year standard deviation, a gauge of volatility, on the Steelpath Select 40 A fund, for example, is 33, compared to 20 for the Vanguard 500 Index fund, which holds the most popular U.S. common stocks, as of Oct. 10. The lower the standard deviation, the lower the price variance. These are not investments for nervous Nellies.
5. Know the costs.
You are also paying for the convenience of owning multiple MLPs. The ALPS product, for example, charges 0.85 percent annually for expenses, compared to 0.57 percent for the industry average.
If you think of MLP funds as limited ways of boosting your income portfolio, don’t get too concentrated in them because while you’re boosting yield, you’re also adding considerably more risk and investment management fees. They are not substitutes for core holdings like broad-based bond and stock funds.