Our philosophy is that it’s better to hold individual MLPs than to buy them through a mutual fund or an ETF. When you buy a fund or ETF, you’re basically buying the bad and ugly of a sector, as well as the good. That’s because ETFs are typically based on indexes, which by definition have to include the players even if they’re badly run.

— Roger Conrad, MLP Profits

I read last week that on March 13th only the second master limited partnership (MLP) exchange-traded fund (ETF) hit the market! This time Exchange Traded Concepts launched an MLP ETF called the Yorkville High Income MLP Index ETF (NYSE: YMLP). Although its portfolio of 22 MLPs and three royalty trusts is similar in size to the only other MLP ETF — the Alerian MLP ETF (NYSE: AMLP) — the similarity stops there. Yorkville tracks the Solactive High Income MLP Index (pp. 22-23), which is:

a rules-based index comprised of MLPs and royalty trusts that meet certain criteria relating to current yield, coverage ratio and distribution growth as determined by Structured Solutions. Market capitalization and liquidity screens will be applied in addition to the fundamental screens for current yield, coverage ratio and distribution growth to ensure sufficient market size and liquidity of the Index components.

The Solactive MLP index strikes me as a mysterious “black box,” so I’m not a fan. In contrast, the Alerian MLP ETF tracks the more-transparent Alerian MLP Infrastructure Index (^AMZIX) which is capitalization-weighted, excludes royalty trusts, is limited to pipeline companies, and includes the largest MLPs (including low-yielding ones). Unlike MLPs, royalty trusts don’t own any productive assets but simply own contractual rights to an energy or mining resource that eventually will become depleted (and worthless).

Bottom line: the Yorkville MLP ETF has a cash distribution yield of 8.5% whereas the Alerian MLP ETF has a yield of only 5.9%. If you want the safety and stability of the largest MLPs like Enterprise Products Partners (NYSE: EPD) and Kinder Morgan Energy (NYSE: KMP) (NYSE: KMR), don’t buy Yorkville because it doesn’t own them.

MLPs’ Outperformance Explains Their Popularity

The existence of eight MLP ETFs and ETNs shouldn’t come as a big surprise. Energy MLPs have outperformed the S&P 500 by a whopping 26 percentage points since the beginning of 2010:

Source: Bloomberg

Investors chase past performance and want more of the same. Wall Street makes its living by the old adage: “when the ducks are quacking, feed them,” so it will churn out as many of these MLP funds as the public will bear.

Different MLP Indices Provide Different MLP Exposure

With so many MLP products to choose from, it can be confusing how they differ. The key is to understand the index each MLP fund tracks and the methodology each index uses to select MLP securities.  If you want exposure only to conservative “pipeline” companies in the midstream sector, buy one of the funds that tracks either the Alerian MLP Infrastructure Index or the Cushing 30 MLP Index. The Cushing 30 index gives you more “juice” because it is equal weighted, with higher-beta small-cap stocks having the same weight as the dodgier large-cap names. Furthermore, the Cushing index provides exposure to the “general partnership” units, which are more leveraged, whereas the Alerian infrastructure index is composed only of the more conservative “limited partnership” units.

In contrast, if you think energy prices are going higher and want exposure to this trend, you should stick with funds tracking the Alerian MLP Index, Tortoise MLP Index, and Wells Fargo MLP Index. All of these indices hold MLPs engaged in “upstream” exploration and production of oil and natural gas. Of these three indices, only the Tortoise MLP Index caps each individual MLP at a maximum holding percentage of 10%, which provides some guarantee of diversification.

Pros and Cons of MLP ETFs vs. MLP ETNs

Keep in mind that the cash distributions of MLP ETNs are treated as ordinary income and consequently the cash distributions of MLP ETNs do not offer investors the tax-advantaged “return of capital” benefits of individual MLPs. Equally if not more unpleasant, MLP ETFs are not permitted to be classified as a “Registered Investment Company” under the 1940 Act because such companies are defined as having investment portfolios that consist of no more than 25% MLP securities. Consequently, MLP ETFs are required to pay corporate tax as “C” corporations and must deduct from their net asset values (NAVs) a “deferred tax liability” equal to the 35% corporate tax rate times:

(1) the tax-deferred “return of capital” portion of cash distributions; plus

(2) the capital appreciation of the ETF itself

The result is that MLP ETFs severely underperform MLP ETNs in bull markets and even in neutral markets. The only time MLPL ETFs outperform is in bear markets. Since MLPs have been in a bull market for many years and are likely to continue to outperform, MLP ETFs look like a bad bet. For example, since the Alerian MLP ETF (AMLP) launched in August 2010, it has severely underperformed the Alerian MLP ETN (AMJ) by almost 13 percentage points:

Source: Bloomberg

According to Barron’s, although MLP ETFs lose in terms of capital appreciation, they win in terms of cash distributions since their distributions are mostly tax-deferred whereas the distributions of MLP ETNs are not. Pick your poison:

In an individual retirement account, it makes sense to go with the ETN. In a taxable account, if capital appreciation is the most important goal, then the ETN still looks like a good choice. But if dividends are of main concern, then AMLP could fill such a niche.

On the positive side, both MLP ETNs and ETFs provide investors with easy-to-understand 1099 forms rather than the more complicated K-1 forms issued by individual MLPs. MLP funds also do not suffer from unrelated business taxable income (UBTI) issues in tax-deferred retirement accounts, whereas individual MLPs do. So, there is a tradeoff between profits and tax filing simplicity.

Individual MLPs Offer Higher Returns Than Either MLP ETFs or MLP ETNs

Personally, the added tax complexity doesn’t bother me because I let my professional tax preparer deal with it. I want the higher returns that individual MLP investments provide! Individual MLPs offer the best of both worlds in terms of taxation: (1) the tax-deferred cash distributions of MLP ETFs; and (2) the lack of corporate taxation enjoyed by MLP ETNs.

For those of you who care more about easy tax filing, however, I thought it would be helpful to summarize how some of the MLP indices differ and which funds track which indices:

MLP Indices and Corresponding Funds

MLP Index	Funds that Track
Alerian MLP Index (NYSE: ^AMZ)	JPMorgan Alerian MLP Index ETN (NYSE: AMJ)
Alerian MLP Infrastructure Index (NYSE: ^AMZI)	Alerian MLP ETF (NYSE: AMLP)   UBS E-TRACS Alerian MLP Infrastructure Index ETN (NYSE: MLPI)   UBS E-TRACS 2x Monthly Alerian MLP Infrastructure Index ETN (NYSE: MLPL)   UBS E-TRACS 1x Monthly Short Alerian MLP Infrastructure Index ETN (NYSE: MLPS)
Cushing 30 MLP Index (Bloomberg: MLPX)	Credit Suisse Cushing 30 MLP Index ETN (NYSE: MLPN)
Tortoise MLP Index (Bloomberg: TMLP)	None, but actively-managed closed-end funds Tortoise Energy Infrastructure (NYSE: TYG) and Kayne Anderson MLP Investment (NYSE: KYN) are close substitutes.
Wells Fargo MLP Index (SNP: ^WMLY)	UBS E-TRACS Wells Fargo MLP Index ETN (NYSE: MLPW)
Solactive High Income MLP Index	Yorkville High Income MLP ETF (NYSE: YMLP)

 

MLP Index Methodologies

Criteria	Alerian MLP	Alerian MLP  Infrastructure	Cushing 30	Tortoise	Wells Fargo
Number of Holdings	50	25	30	64	66
Weighting Method	Market-cap weighted	Market-cap weighted	Equal weighted	Market-cap weighted	Market-cap weighted
Rebalance Frequency	Quarterly	Quarterly	Quarterly	Quarterly	Quarterly
Market Cap Threshold	$250 million; $500 million preferred	$250 million; $500 million preferred	$500 million	$200 million initial; 20-day average of $175 million prior to rebalance	$200 million initial; 30-day average of $175 million prior to rebalance
Liquidity Threshold	6-month median daily trading volume >= 25,000; 50,000 preferred	6-month median daily trading volume >= 25,000; 50,000 preferred	Trading volume of greater than 500,000 per month for each of past 6 months; annual dollar value >= to 30% of market cap	No	No
Public Float Requirement	Investable Weight Factor >= 20% preferred	Investable Weight Factor >= 20% preferred	Investable Weight Factor >= 20%	No	No
Financial Viability	Four consecutive quarters of distribution >= minimum quarterly distribution	Four consecutive quarters of distribution >= minimum quarterly distribution	Maintained or increased distribution for last four quarters	Distribution >= minimum quarterly distribution	No
Individual Security Weighting Cap	No	1st – 2nd: 9.49%   3rd – 6th: 6.99%   7th – 25th: 4.74%	3.33%, since equal weighted	10%	No
Minimum Share Price	Above $5 each trading day during last full month preferred	Above $5 each trading day during last full month preferred	No	No	No
Exploration & Production Companies Included?	Yes	No	No	Yes	Yes

MLPs are Still a Good Buy

With the mad dash to offer new MLP funds, the burning question many investors are asking now is: “is it too late to buy MLPs?” Elliott Gue and Roger Conrad, co-editors of MLP Profits, recently answered a resounding “no” to this question, telling subscribers that MLP fundamentals remain strong:

Strong market performance doesn’t mean a security class is necessarily overvalued. High yields and consistent distribution growth justify the gains posted by MLPs over the long term.

There you have it: MLPs are not overvalued.

Editor’s note: Roger Conrad gives away 6 free MLP stock picks in his special report, The Best MLP Investments to Own Now.