By my count, there are currently 35 investment products designed to invest the majority of their assets in MLPs or track the returns of MLP-related indices, 23 of which were launched since the beginning of 2010. At this rate, it won’t be long before there are more MLP ETFs, ETNs and mutual funds than there are actual MLPs (80). In the ETFs, ETNs and closed end funds there are now $18.8 billion, and several billion more in open end mutual funds.
MLPs limped to the finish line this quarter as the Alerian MLP Index notched its second worst March ever (since index started in 1996) at -4.0%. For the full quarter, the Alerian MLP Index tallied total returns of just 2.0%, compared with 12.0% for the S&P 500.
It turns out, however, that many of the 35 MLP investment products outperformed the MLP Index, the closed end funds in particular. MLP closed end funds averaged 8.1% total returns in the first quarter of 2012. MLP ETNs did ok, notching 2.6% total returns. The open end mutual funds and the ETFs underperformed.
Closed end funds came out ahead this quarter for lots of fund-specific reasons, but generally they outperformed because they were not 100% invested in MLPs. Closed end funds generally have rules that mandate 60% to 80% of their assets must be invested in MLPs, but some of that can be invested in debt of MLPs, and the remaining 20% can be invested in virtually anything.
Back to the fund-specific reasons, Kayne Anderson Energy Development Company (KED) led the group with 21.6% returns, followed by Cushing MLP Total Return Fund (SRV) up 14.4%. KED currently holds only around 57% of its assets in MLP equities, 16% in debt and 26% in private equity. That private equity piece drove the higher returns so far this year. SRV outperformed because it actively shorts the Alerian MLP ETN (AMJ) and the Cushing 30 MLP Index ETN (MLPN). SRV was short the equivalent of 23.8% of its portfolio as of January 31, 2012. In times when MLPs are down, it’s nice to have some private equity or to be able to take a temporary directional position against the sector. It has worked out well for these two winners and for most other MLP closed end funds to date.
Countless articles have been written to highlight the shortcomings of these MLP derivative investment products, in particular with regards to the first MLP ETF, the Alerian MLP ETF, that launched in August 2010 (including this post by me). There has since been a second ETF that launched last month, with equally poor tracking and fee disclosure. Closed end funds don’t track indexes well either, and they employ leverage to keep dividends high, but they at least offer active management as a justification for their fees.
There is clearly a large demand for products catering to investors who don’t feel comfortable owning MLPs in a tax-exempt account, don’t like K-1s, would like to exposure to the sector via an index, or just prefer professional management. The alternatives available are listed below alongside their primary drawback relative to owning an MLP portfolio directly:
- Closed-end funds: leverage adds financial risk, fees can be high
- Open-end mutual funds: taxes, tracking
- Exchange traded notes (ETNs): counterparty risk exists with bank sponsor, income taxed at ordinary income rates
- Exchange traded funds (ETFs): poor tracking because of daily tax leakage
I contend that the best way for amateur MLP investors to get exposure to MLPs with professional management is with separately managed account (SMA) programs. When investors hire a manager (like me) to manage a separate account invested in MLPs, they get professional management, but they own the MLPs directly and get to realize the tax benefits of direct ownership. SMA investors also don’t have their assets co-mingled with other investors (hence the key word “separate”), and they get to monitor the portfolio holdings on a daily basis. SMA programs usually have at a minimum of $250,000. Most conservative investors wouldn’t feel comfortable with more than 20% of their portfolio represented by MLPs, so SMA investors usually have more than $1.0 million in investable assets. For the rest of you, MLP focused closed end funds are not a bad choice.
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