MLPs Have Come a Long Way, Baby

Yield hunt, commodities demand bring more Master Limited Partnership funds, ETFs to market.

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They may not have always had the best reputation, but Master Limited Partnerships (MLPs) are worth a new look.

MLPs, which trade on major exchanges, grant a "partnership" share in a project or business enterprise, like a natural gas pipeline. Individuals or asset managers buy an ownership stake, and shares trade much like stocks. There are more than 90 MLPs on the market, with the majority in industries related to energy and natural resources.

They're growing in popularity now because the partnership structure offers investors a rare income source in this low-yield world, paying north of 5 percent, on average, compared with near-zero or even negative bond yields. Plus, MLP indexes have outperformed the broader equity market over the past decade.

[See Where to Invest in 2012.]

They're also a straightforward energy play that keeps investors from full submersion in an oil market that can prove a bit too sticky for the retail investing crowd.

That's a shift from a checkered past, where MLPs' historic illiquidity and lack of transparency earned them the unfortunate nickname "roach motel," as in the famous commercial jingle: You can get in, but you can't get out.

Now, their rise in popularity is evident in an increasingly crowded field of MLP-focused mutual funds and exchange-traded funds (ETFs).

"Investors are increasingly seeing the value in MLPs as a permanent allocation to their portfolios as a way to provide the potential for compelling yield, attractive total return potential, and low correlation to the broader market," says Gabriel Hammond, CEO and portfolio manager at SteelPath, which rolled out the first MLP mutual fund a little over two years ago.

"MLPs are a little less volatile than stocks but more volatile than bonds," says R. Scott Raynovich, editor-in-chief of the blog and news site Investor Uprising, which has produced an MLP Investment Guide. "During the 2008 financial crisis, MLPs lost a fraction of what stocks did—while at the same time paying dividends in excess of 6 percent. So you can expect them to reflect some of the risk of the equity market, while providing a higher yield than equities."

[See Should You Have ETFs in Your Portfolio?]

A little history. MLPs pay out the vast majority of their profits (up to 90 percent) after expenses in cash distributions (similar to dividends) to shareholders. MLP investors have historically received a generous income stream—even greater than those holding MLPs' utility-company cousins. The lack of institutional ownership in MLP units has caused the indexes' fluctuations to act somewhat independently of other equity markets. Returns to high-yielding MLPs are, however, often correlated to interest-rate changes. Broad market indexes, such as the S&P 500, typically have little to no representation of MLPs in their construction, so portfolio overlap worries are minimal, according to Morningstar ETF analyst Abraham Bailin.

Investors might, for example, opt for an MLP that operates a pipeline and charges a "toll" for the interstate flow of oil and natural gas, says Jay Wong, co-manager of the Payden Value Leaders Fund (PYVLX). Most pipelines are natural monopolies. New constructions must justify their economic viability, so few face direct competition. Pipeline revenues are linked to volume, not the far more volatile prices of the commodities they carry. Once assembled, pipelines tend not to require significant variable input costs for maintenance, so they render significant free cash flow. Like most monopolies, pipelines operate under regulatory constraints meant to protect public interests, Bailin notes.

In August 2010, Alerian, the company that manages the benchmark MLP index, launched the first MLP exchange-traded fund, the Alerian MLP ETF (symbol: AMLP).

"Motivations for investors holding AMLP are likely to include beliefs that the country's basic infrastructure requires further investment, that these companies will continue to be able to tap capital markets effectively, that fuel demand will stabilize or start growing going forward, and that interest rates will not dramatically increase. While it may be quite a multifaceted thesis, all of those factors will ultimately decide this fund's fate," says Morningstar's Bailin.