The MLP Profits Portfolio currently includes seven Aggressive Holdings, all, to some extent, bullish bets on commodity prices. We also feature six Conservative Holdings, which have little or no commodity price exposure, and six Growth Holdings that have some exposure but are mostly fee-based enterprises.

One member of group three is a closed-end mutual fund specializing in master limited partnerships (MLP), Kayne Anderson Energy Total Return Fund (NYSE: KYE). Kayne Anderson Energy trades at a slight premium to the value of its assets and yields a little over 7 percent.

We favor Kayne Anderson Energy over the other closed-end funds in How They Rate for several reasons. First, management has a strong, long-term track record. Although 2008 was a downer, no one panicked, and the losses have since been recouped and then some. Second, the premium is smaller than most funds, particularly the equally solidly performing Tortoise Energy Infrastructure (NYSE: TYG)–meaning more of your money goes to work for you.

Third, Kayne Anderson Energy’s yield is about a percentage point more than Tortoise Energy Infrastructure. It sticks to generally conservative MLP choices and flavors them with some holdings in Canada and elsewhere, providing some currency hedge against potential problems with the US dollar. That’s an advantage is has over the other two Kayne Anderson funds we track.

Note that Kayne Anderson Energy Development Company (NYSE: KEY) is an entirely different animal, owning shares of development MLPs rather than widely traded ones. The risks of that strategy explain its 11 percent discount to net asset value. But if you’re interested in holding MLPs as a conservative long-term investment, we strongly urge you buy Kayne Anderson Energy Total Return Fund, up to 27.

Current tax law exempts investors in mutual funds like Kayne Anderson Energy that hold MLPs from having to file K-1s at tax time. Rather, holders receive a Form 1099, with cash disbursements divided into ordinary income, qualified dividends and sometimes capital gains. And no matter how many MLPs are held by the fund, there’s never any UBTI (unrelated business taxable income) liability. And this tax simplicity also applies to exchange-traded funds (ETF) that hold MLPs.

Our philosophy is that it’s better to hold individual MLPs than to buy them through a mutual fund or an ETF, for several reasons. First, 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.

Second, not only do you have no control over what you own in a fund or ETF. Odds are you won’t know at any given time just which ones you own, either. Managed funds in particular are often a black box. You may be holding one that’s a lot more leveraged to a particular MLP than you want to be, should a manager be shooting for high returns in a given quarter.

Finally, funds and ETFs don’t invest your money for free. Rather, there are fees involved that come directly out of your distributions. That, too, may cause a fund manager to take on more risk, in order to keep the yield paid at a competitive level.

There are times, however, when it may make sense to hold a fund, ETF or exchange-traded notes (ETN), investment vehicles similar to ETFs but with subtle differences. This week I explored some of these with Benjamin Shepherd, editor of MLP Profits’ sister letter Global ETF Profits.

Here’s an edited transcript of my questions and his answers to your MLP ETF questions.

Roger Conrad: Ben, how many exchange-traded funds are there specializing in master limited partnerships?

Benjamin Shepherd: Right now, I’m tracking seven ETFs and ETNs in Global ETF Profits, which that I co-edit with Yiannis Mostrous. But not all of them are worth investors’ time. Some of them are based on very narrow indexes, which may be great for institutional players but offer little value for retail investors and others are simply too expensive.

Roger: What’s the difference between an ETF and an ETN?

Ben: An ETF is just a basket of stocks, commodity futures or some other hard investment that’s designed to mirror the sector performance of that investment. If one is pegged to a specific stock index like the S&P 500, that ETF will literally hold every stock in the S&P 500, and at least initially in proportion to how that stock is weighted in that index.

An ETN–or exchange traded note–is designed to do much the same thing but is organized much differently. Rather than a basket of stocks, it’s actually a junior unsubordinated debt agreement. Its performance will still mirror the investment sector or index it’s designed to. But at its core, the ETN is a debt obligation of the issuer.

The popular JPMorgan Alerian MLP Index (NYSE: AMJ), for example, is really an obligation of JPMorgan Chase (NYSE: JPM). Theoretically, should Morgan go belly up so would the ETN, even if MLPs were the hottest investments on Wall Street. That’s a major reason these ETNs have had trouble catching on in recent years; in the event of a bankruptcy ETN investors would more often then not be left with nothing, whereas ETF investors would get cashed out at net asset value. The memory of the 2008 crash is just too fresh.

Roger: Why would someone prefer an ETN to an ETF?

Ben: The key advantage of ETNs over ETFs for the issuer is that they’re much more profitable to run. The key advantage for investors is they’re more tax efficient than ETFs. Because they’re effectively obligations of the issuer, they enjoy the flexibility to avoid taxes on distributions that ETFs cannot. That flexibility also allows issuers to offer more specialized fare, or what I like to call exotic exposure in portfolios.

In the MLP universe, an example would be UBS E-Tracs Alerian Natural Gas MLP Index ETN (NYSE: MLPG), which tracks only MLPs that hold natural gas infrastructure. I’m not saying you couldn’t do the same thing in an ETF, but it would likely be a great deal more cumbersome, particularly with the current MLPG market capitalization at just $10.87 million.

Roger: I can see why investors would be nervous about buying ETNs from big banks and brokerages that were only recently on the edge.

Is there any way to protect against an issuer bank default on an ETN?

Ben: No. If the issuer goes bust, you’re out of luck. I would point out, though, that these issuers are all very large banks. It’s likely any MLP-focused ETN would crater in a broad stock market decline long before issuer solvency ever became a concern. Also, looking at the third-quarter earnings of some of the issuers such as Morgan, earnings and financial strength seem to be moving in the right direction.

But look, if you have the choice, why take this risk? If there’s an ETF that does the same thing as an ETN, I’ll go with it. Also, like I said before, ETF yields are usually better because you don’t have the additional expenses and operating costs taken out as you do with ETNs.

Roger: What about taxes?

Ben: On the plus side, investors in ETFs and ETNs avoid the complications of investing in individual MLPs. There are no K-1s to file at tax time. And no matter how much of them you own, you won’t owe any UBTI, either. This really simplifies the complexity of holding MLPs in IRAs and other tax-deferred accounts. In fact, the ease of IRA investing is one of the main reasons these investment vehicles were launched.

On the negative side, investors who own MLPs in ETFs or ETNs lose what’s historically been the key benefit of owning this asset class: the fact that MLP distributions are, in large part, return of capital (ROC).

As your readers know, you don’t pay tax on the portion of the distribution that’s return of capital in the year you receive it. Rather, ROC is subtracted from your cost basis. When you sell the MLP, you pay the difference between the cost basis and selling price. But you pay at the long-term capital gains rate, which is generally the lowest rate available. And if you will your MLPs to your heirs, there’s a step-up in the cost basis to the current market price. That tax liability is literally wiped clean.

Again, if you own MLPs in an ETF or ETN, you’ll be paying taxes in the year you receive income. It will be easier to file taxes. But you’ll be paying more of them. And if Congress and the Obama administration don’t extend preferential tax rates on dividends in 2011, that rate could be quite a bit more.

Roger: My co-editor Elliott Gue and I believe strongly that investors, particularly those looking to lock in high dividends, will do better picking their own MLPs, rather than buying an ETF or ETN.

Some of our readers, however, are looking for short-term trades on the sector, either bullish or bearish. And some are looking for ways to hedge their exposure in what have become rather large MLP portfolios. How can ETFs and ETNs help them?

Ben: First of all, I disagree with your premise that there aren’t some interesting longer-term ETF/ETN plays on MLPs. It really does depend on what investors’ objectives are. And the structure has really allowed major brokerages to get creative.

The important thing is for investors to know what they’re buying and to look for the vehicle that most closely tracks what they want to do. That’s in large part a function of liquidity–the larger its market capitalization the more true the ETF/ETN’s performance will be to what it’s been set up to follow. Usually, the first-movers to a sector will be the largest and therefore the best plays, though that’s not always the case as a particularly good launch can push a particular ETF/ETN into the leading position.

Roger: If the first-movers and largest ETFs/ETNs are the best plays, is there really any need for so many specializing in MLPs, or any other sector for that matter?

Ben: Frankly, no.

What I see is that firms are out there throwing ideas against the wall when they create new ETF/ETNs, just as they do any products. They throw something out there, and if it works, great. You only need $20 million for the typical ETF/ETN to be profitable and for management to be able to justify keeping it around, so the profits come pretty quickly.

And if something doesn’t work, they get rid of it and move onto something else. Five or 10 ETFs/ETNs in a particular sector can become two in a hurry. That doesn’t mean investors lose anything when one is liquidated–you don’t. But it does demonstrate pretty clearly that these firms don’t have any real attachment to any of these vehicles. In fact, many ETFs/ETNs are really just money-making gimmicks for their issuers.

The increased competition is one positive that comes out of all of this, though. As a niche becomes more competitive, it’s not uncommon to see expense ratios charged by most–if not all–of the funds operating in it fall. Lower expenses are always a good thing.

Back to your question about using ETFs to hedge a portfolio of MLPs; there is a vehicle. It’s UBS E-TRACS 1X Short Alerian MLP Infrastructure ETN (NYSE: MLPS). It’s an ETN, and so the obligation lies with UBS (NYSE: UBS). Its value is set up to rise one percentage point for every percentage point decline in the Alerian MLP Infrastructure Index. The Infrastructure Index is a subset of the greater Alerian MLP Index and owns many of the MLPs in your Conservative Holdings.

The sister ETN to UBS E-TRACS 1X Short Alerian MLP Infrastructure is UBS E-TRACS 2X Leverage Long Alerian MLP Infrastructure ETN (NYSE: MLPL). It’s based on the same index and is also a UBS obligation. The difference is that it’s set up to rise two percentage points for every one percentage point rise in the Alerian MLP Infrastructure Index.

To be honest with you, I wouldn’t use these funds to leverage or hedge a portfolio of MLPs. The reason is both reset their holdings on a monthly interval. Unless you’re resetting your MLPs along with them, you’re not really going to hedge your holdings, other than in a very general, sector-focused way. This reset means that over time, these ETFs and ETNs are not going to perform even remotely like the index. They’re really only good for holding a few weeks–that is, in between resets. And if you’re holding on the day that the resets hit, your position will get totally out of whack.

What investors have to understand is that most ETF/ETNs have been created for the sole purpose of allowing institutional traders to run their unique strategies. They’ll gladly take on individual investors, as that increases the market capitalization of the ETFs/ETNs, and so their profits. But they really didn’t design a lot of these things with your average individual investor in mind.

Roger: What ETFs/ETNs should our readers consider?

Ben: There are some that I like. Alerian MLP ETF (NYSE: AMLP) is an exchange-traded fund that tracks the price and yield performance of the Alerian MLP Infrastructure Index of 25 fee-generating MLPs. UBS E-TRACS Alerian Natural Gas MLP Index ETN (NYSE: MLPG) is an exchange-traded note–and an obligation of UBS–that tracks the Alerian Natural Gas MLP Index. I’m willing to overlook the fact that it’s an ETN because it provides sector exposure to natural gas infrastructure MLPs, which, as you know, are profiting from the explosion in shale gas drilling in North America.

The Alerian MLP ETF is a pretty good way to hold a number of the MLPs you like–such as Enterprise Products Partners LP (NYSE: EPD)–in a reasonably low-risk way. It’s also managed to achieve escape velocity as an ETF with a market capitalization of $292 million, largely because it’s the only pure ETF in this sector. The rest are ETNs, which still have that stigma of being too closely tied to the fortunes of major banks.

As I said, UBS E-TRACS Alerian Natural Gas MLP Index ETN is attractive to me mainly because I can have exposure to a sub-set of MLPs that are attractive now. It’s not nearly as liquid as Alerian MLP ETF, with less than $11 million in market capitalization. But it is the only game in town. The bid/ask spread stays fairly tight, but if you want to take a position definitely use limit orders rather than market orders.

Roger: What about the most popular MLP ETF/ETN, JPMorgan Alerian MLP Index?

Ben: If someone wants the broadest possible exposure to US-listed MLPs, this is definitely the one to look at. It was first to the party and now has a market capitalization of nearly $2 billion.

My problem with it is it holds literally everything in the sector, including quite a few MLPs that have nothing to do with energy. That, as you know, could leave it vulnerable to legislation that would do away with the use of carried interest tax shelters.

On the plus side, the Alerian’s performance will definitely mirror the popularity of MLPs, and it has done quite well since the market bottomed in March 2009. But you’re definitely getting the bad as well as the good. It’s also an ETN, and so uniquely vulnerable any time the market starts to worry about the health of major banks.

Roger: What’s your view on the commodity-based vehicles such as United States 12-Month Oil Fund LP (NYSE: USL), which we track in the MLP Profits How They Rate coverage universe?

Ben: As you know, these are not really ETFs or ETNs, though they are definitely similar in some ways as exchange traded products. They give the investor a way to own an asset and participate in its appreciation with minimal complications–in this case oil, gasoline, heating oil and natural gas.

There’s also a fairly unique risk that goes along with these types of futures-based funds because of position limit issues. Over the summer United States Natural Gas (NYSE: UNG) ran up to a huge premium at the end of 2009 because it took quite some time to get permission from the Commodity Futures Trading Commission to take a larger futures position to facilitate the share creation process. As a result there weren’t enough United States Natural Gas shares in the market, causing a big run-up in share price–something that’s not supposed to happen with exchange-traded funds. The problem was finally resolved, but it’s still a looming issue.

I think they’re OK as long as investors understand they’re not getting a play on the spot price of these commodities, but rather on the futures market price contango. Profits and losses will be determined by energy prices, and liability is limited to the purchase price, unlike commodity futures where profit and loss are theoretically unlimited. But investors should definitely understand that before buying in.

Roger: Thanks, Ben. Can you tell us where to get more information on your service?

Ben: Clicking here will take you to information about my Global ETF Profits service. Thanks, Roger.

Earnings on the Way

Three MLP Profits Portfolio recommendations have announced third-quarter earnings thus far. From the Conservative Holdings, Enterprise Products Partners LP (NYSE: EPD) and Kinder Morgan Energy Partners LP (NYSE: KMP) have released numbers, while Navios Maritime Partners LP (NYSE: NMM) is the first to do from our Aggressive Holdings.

Enterprise Products Partners reported gross operating margin rose 29 percent over year-earlier levels, with the MLP reporting improved results over all of its business segments. Petrochemical and Refined Products Services turned in the sharpest improvement, with margin rising 138 percent.

The key is the MLP’s expanding asset base in the hottest areas of energy drilling across North America, including the still-hopping Haynesville Shale and Barnett Shale and the emerging gas liquids-rich Eagle Ford Shale. Enterprise Products has now achieved the scale and financial power to enter virtually any new project. And its cost of equity and debt capital has never been lower. The result is a stream of new projects that will keep cash flow and distributions rising at a steady clip, likely for years to come.

The expansion of the newly acquired State Line Gathering System, for example, lifted Enterprise Products’ fee-generating capacity by 75 percent in the Haynesville Shale last quarter. And there’s potential to ramp it up another 70 percent in coming months, should conditions warrant.

Distributable cash flow (DCF) covered the distribution–which was raised for a 25th consecutive quarter this month–by a rock-solid 1.4-to-1 margin. Put another way, the MLP was able to retain 23 percent of its DCF to reduce debt and invest in more cash-generating capital projects. One area sure to receive a great deal of interest is natural gas liquids, which are seeing a boom thanks to price spreads of 30 to 35 percent with crude oil. The deal inked with EOG Resources (NYSE: EOG) in the Eagle Ford Shale ensures Enterprise will be right in the middle of everything that happens.

Some of our readers have queried whether, given its strong run-up of recent months, Enterprise Products is due for a pullback. To be sure, nothing grows to the sky, and the MLP has broken out to a new all-time high. On the other hand, this model is working and, though lower than in the past, the tax-advantaged and growing 5.6 percent yield is still competitive.

Put another way, the MLP is growing enough as a business to justify its rising unit price. As a result we’re raising our buy target to 42 for those who don’t yet have a position in Enterprise Products Partners LP.

Kinder Morgan Energy Partners’ third quarter was not as robust as that of Enterprise Products Partners, owing mostly to a more conservative business mix. Nonetheless, DCF is up 16 percent from last year’s levels, and management is again raising the MLP’s distribution level, this time by 6 percent to a new quarterly rate of $1.11 per unit.

Performance was steady to rising at all business segments. Products Pipelines saw a 3 percent boost in segment earnings, as the company expanded operations at its Pacific pipeline and West Coast terminals. Kinder Morgan Energy’s strong exposure to the ethanol market was again a plus, boosted by a mandate in California that took effect during the quarter. Ethanol volumes handled rose 25 percent from year-earlier levels during the quarter and are now up 34 percent of the first nine months of the year.

Reliance on ethanol traffic also means Kinder Morgan Energy is somewhat exposed to the ebb and flow of gasoline volumes in markets around the country. Happily, these are again on the rise after the recession-related fall-off of recent years. Jet fuel volumes remain weak but are balanced by growth in natural gas liquids.

Over the next several quarters, the completion of major new fee-generating projects will drive cash flows and distributions higher. Front and center is the Fayetteville Express Pipeline, which will be fully operation on December 1, ahead of schedule and under budget. The long lagging carbon dioxide (CO₂) business–which transports CO₂ for usage in unconventional oil and gas production–is back on track, with the company signing on eight customers to contracts averaging 8.5 years.

Kinder Morgan Energy continues to pay out an aggressive portion of distributions, with the coverage ratio basically 1-to-1 in the third quarter using the newly raised payout. Given the surety of future cash flows, however, there’s little risk and every reason to expect more boosts ahead. Units have surged this fall to new all-time highs. But as is the case with Enterprise, growth has risen to justify the loftier unit price with room to spare. As such, we’re raising our buy target for Kinder Morgan Energy Partners LP to 72.

Navios Maritime Partners is a more aggressive play than Enterprise Products or Kinder Morgan Energy, mainly because cash flows depend on fees it gets from its dry-bulk shipping fleet. Fortunately, these remain robust, even as the company has now successfully dealt with the risk of a drop-off early next year as certain contracts expired.

Third-quarter operating surplus–cash flow after expenses–rose 81 percent from year-earlier levels, spurring a 73 percent boost in cash flow. Meanwhile, the company entered new contracts that essentially eliminate re-chartering risk in the second half of 2012. The average life of the company’s fleet is now just six years, with an average life of contract now at 4.3 years.

Cash flow growth is in large part due to successful additions of vessels to Navios Maritime’s fleet. Over the past year the company was able to take advantage of the weak economy to add four vessels, lifting charter revenue by 61 percent. It now operates 14 vessels. Capital reserve for replacement, meanwhile, now stands at $3.8 billion, nearly double last year’s levels. Management has also kept a tight rein on expenses despite the additions, including debt costs.

Distribution covenant–a measure of payout safety used by the company–came in at 2.56-to-1 for common units in the third quarter and 2.1-to-1 for all units. That’s solid ground on which to base more distribution growth. So is the fact that 100 percent of the fleet is now contracted out through 2012.

In a larger sense the growth of Navios Maritime and other shippers is linked to surging import demand for dry-bulk commodities in India and China, which continues to push shipping rates higher and open opportunities to grow the fleet. That’s a trend set to continue for a long time to come, as both countries urbanize and therefore require more raw commodities.

Like other MLPs, Navios Maritime has spent most of the last 18 months recovering the ground lost during the 2008 market meltdown. Even after a 12-month return of 64 percent, however, it still yields nearly 9 percent, with another distribution increase likely early next year.

With strong third-quarter numbers now on the books, we’re buyers of Navios Maritime Partners LP up to a new target of 20.

Here’s when we expect to see the rest of our holdings report, based on management statements and estimated reporting dates when there’s been none (indicated with an “e” in parentheses). We’ll be tracking the results weekly in MLP Profits, along with any advice changes if needed.

Conservative Holdings

• Genesis Energy Partners LP (NYSE: GEL)–Nov. 4
• Magellan Midstream Partners LP (NYSE: MMP)–Nov. 2
• Spectra Energy Partners LP (NYSE: SEP)–Nov. 4
• Sunoco Logistics Partners LP (NYSE: SXL)–Oct. 28

Growth Holdings

• DCP Midstream LP (NYSE: DPM)–Nov. 4
• Energy Transfer Partners LP (NYSE: ETP)–Nov. 9 (e)
• Inergy LP (NSDQ: NRGY)–Nov. 30 (e)
• Kayne Anderson Energy Total Return Fund (NYSE: KYE)–N/A
• Targa Resources Partners LP (NSDQ: NGLS)–Nov. 4 (e)
• Teekay LNG Partners LP (NYSE: TGP)–Dec. 8 (e)

Aggressive Holdings

• Encore Energy Partners LP (NYSE: ENP)–Nov. 4
• EV Energy Partners LP (NSDQ: EVEP)–Nov. 9 (e)
• Legacy Reserves LP (NSDQ: LGCY)–Nov. 3
• Linn Energy LLC (NSDQ: LINE)–Oct. 28
• Penn Virginia GP Holdings (NYSE: PVG)–Oct. 28
• Regency Energy Partners LP (NSDQ: RGNC)–Nov. 9

Editor’s Note: For additional information on this topic, check out the latest report about Master Limited Partnerships written by Roger Conrad and Elliott Gue.