May 1, 2012
One would think that an asset class yielding 7% and carrying less volatility than do equities would be popular with investors. Yet, despite those attributes, master limited partnerships (MLPs) remain unknown or ignored by large numbers of investors. The case for MLPs is compelling, so it’s time for a deep examination of the special properties of this asset class.
MLPs are publicly-traded limited partnerships that own and operate energy infrastructure assets, such as pipelines and storage facilities. The companies in this space offer a wide range of services, including the transportation, storage, gathering, processing and marketing of natural gas, oil, and other energy commodities.
Many prominent authors, including William Bernstein (The Four Pillars of Investing), Christopher Jones (The Intelligent Portfolio) and Burton Malkiel (A Random Walk Down Wall Street) do not mention MLPs in their classic works. But my own research, which I shared in October of 2010 and again in August of 2011, has argued for a meaningful allocation to MLPs. Aiming to construct portfolios that provide maximum yield at modest levels of risk, I found that a 15% allocation to MLPs was ideal.
Let’s explore the basic features of MLPs and examine the reasons investors and advisors should consider MLPs among the core asset classes needed to build complete and effective portfolios.
What are MLPs?
While MLPs are listed on exchanges, owning a unit of an MLP is different from owning a share in a public corporation – units in an MLP have a different tax treatment, which I will discuss later on.
To understand MLPs, consider two specific examples that are typical of the class:
Kinder Morgan Energy Partners (KMP), one of the largest pipeline transport and energy storage firms in North America, delivers refined petroleum products through 8,400 miles of pipelines, natural gas through 16,200 miles of pipelines, and CO2 through 2,000 miles of pipelines. The company also manages eight oil fields and a number of terminals and storage facilities for natural gas and oil. In total, Kinder Morgan operates more than 38,000 miles of pipelines.
Enterprise Products Partners (EPD), another large MLP, operates 16,650 miles of pipelines for transporting natural gas liquids, as well as terminal and storage facilities with a capacity of 156 million barrels in usable storage. The company operates 20,200 miles of natural gas pipelines, along with natural gas storage facilities totaling 14 billion cubic feet. The company also operates 5,250 miles of onshore oil pipelines and storage facilities with a capacity of 12 million barrels. The company’s operations span most of the United States.
MLPs are not highly sensitive to the prices of the commodities for which they provide transport and storage, because the revenues of MLPs are based on the volume of the commodities they handle, using a “toll road” business model. Even with very low prices on natural gas in recent years, MLPs have been able to maintain high yields.
Asset class performance
MLPs are especially attractive for several reasons. In the current low-rate environment, MLPs offer high levels of income. J.P. Morgan reported that MLPs have generated 6-7% per year in yield, plus an average of 8% per year in capital appreciation, over the last 20 years.
MLPs have historically exhibited a low correlation between their returns and the returns of other major asset classes. For the period from January 2002 through December 2011, for example, Cushing, an asset management firm, found that the correlation between their MLP index and the S&P 500 was 0.49, and the correlation between their MLP index and an aggregate bond index was 0.62. The correlation of their MLP index to REITs is 0.35; to high-yield bonds, it is 0.24.
The performance of MLPs was exceptional over the 10-year period that ended in 2011. A recent analysis by Libby Toudouze of Cushing found that MLPs generated the highest risk-adjusted returns among major asset classes over the last 10 years.
The MLP sector is highly liquid; it has a total market cap of $325 billion across 11 sub-sectors and more than 100 companies, according to Toudouze.
Part of the reason that MLPs are getting so much attention is their performance over the last 10 years, during which time many asset classes have under-performed their historical averages. Going forward, however, a more solid rationale than past performance is necessary.
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