MLPA: Strong And Steady Yield Backed By Capital Gains Scope

– by Snehasish Chaudhuri, MBA (Finance)

Global X MLP ETF (NYSEARCA:MLPA) invests in some of the most popular, most liquid midstream Master Limited Partnerships (“MLPS”). MLPs typically pay high yields to investors because they do not have to pay corporate income taxes. MLPA invests in midstream pipelines and storage facilities that have less sensitivity to energy prices. MLPA has a reasonable asset under management (“AUM”) of $1.3 billion and a low expense ratio of 0.45 percent. A strong and steady yield and substantial capital gains make this fund quite lucrative. However, investors have to encounter commodity risk, concentration risk, business structure risk, and high volatility due to the very nature of its portfolio.

Global X MLP ETF

Global X MLP ETF is a non-diversified exchange-traded fund (“ETF”) launched on April 18, 2012. It is managed by Global X Management Company LLC, which invests in stocks of companies and MLPs operating in energy, oil, gas and consumable fuels, oil and gas storage and transportation, storage, and processing of natural resources sectors. The fund fully replicates the Solactive MLP Infrastructure Index. The underlying index is intended to give investors a means of tracking the performance of the energy infrastructure MLPs. Both the index and MLPA rank MLPs and allocate resources on the basis of market capitalization, i.e., the largest MLP typically gets the highest share of the fund’s investments, whereas the smallest MLP gets the least.

Performance of MLPA’s Portfolio

By investing primarily in 18 MLPs, MLPA has built an extremely concentrated portfolio. However, all such holdings have delivered positive returns during the past year. This may be one of the exceptions during a depressed equity market. Out of these 18 MLPs, 13 MLPs have recorded a price growth in excess of 26 percent. These stocks are – Enterprise Products Partners L.P. (EPD), Energy Transfer LP (ET), MPLX LP (MPLX), Western Midstream Partners, LP (WES), Plains All American Pipeline, L.P. (PAA), Cheniere Energy Partners, L.P. (CQP), DCP Midstream, LP (DCP), Genesis Energy, L.P. (GEL), Delek Logistics Partners, LP (DKL), Shell Midstream Partners, L.P. (SHLX), PBF Logistics LP (PBFX), EnLink Midstream, LLC (ENLC), and Phillips 66 (PSX).

And the best part is that these 13 stocks constitute almost three-fourths of MLPA’s total holdings. This surely explains the robustness of MLPA’s portfolio. On the back of such strong performances of those MLPs, Global X MLP ETF’s price grew by 21 percent during the past one year. However, over the medium and long term, MLPA’s price growth has been disappointing and negative. Despite that, MLPA has always been able to record positive total return due to its strong yield. During the past 10 years, MLPA generated an average yield of almost 8.5 percent. Moreover, it has been successful in delivering consistent quarterly pay-out since the very beginning.

Advantages of Master Limited Partnerships

Master limited partnerships are nothing but publicly-traded limited partnerships. They are considered the aggregate of their partners rather than a separate legal entity. There are two types of partners – general partners and limited partners. Those who provide capital in MLPs are called limited partners, and they are eligible for proportionate shares of MLP’s income, losses, deductions, and credits. Limited partners are also known as silent partners. On the other hand, those who operate the day-to-day business of these MLPs are called general partners. They receive compensation based on the partnership’s business performance.

MLPs technically have no employees, and the general partners are responsible for providing all necessary operational services. General partners usually hold 2 percent stakes in the MLP and also have the option to increase their ownership. MLPs are often in slow but steadily growing industries, like pipeline construction, and earn a stable income often based on long-term service contracts. Due to this, MLPs can generate steady cash flows and offer consistent cash distributions. This slow and steady growth also reduces the risk of MLPs. MLP’s business structure also helps in reducing the cost of capital in capital-intensive businesses like energy.

MLPs combine the tax benefits of a private partnership while enjoying the scope of raising funds like a publicly-traded company. Like publicly traded companies, MLPs can be traded in stock exchanges. An MLP issues units instead of shares, which are traded in stock exchanges. Thus the investors in MLPs are commonly referred to as unitholders, rather than as shareholders. In addition, the MLPs are exempted from federal income taxes. Due to their public listing and absence of double taxation, MLPs can generate more funds for their future projects. The availability of capital makes the MLPs competitive within their respective industries.

Risks Associated with Investing in MLPs and Global X MLP ETF

Global X MLP ETF invests in the energy industry, which is a cyclical industry, and thus involves risk and volatility. Due to its concentration on 18 MLPs, all of them operating in the same sector, MLPA also faces concentration risk, i.e. risk due to lack of diversification. MLPA again invests in small-cap and mid-cap MLPs, which are riskier than larger companies. Risks of investing in MLPs again differ from investments in common stock. Unlike common stocks, investors in MLPs get limited control over the entity and limited rights to vote. MLPA is also taxed as a regular corporation for federal income tax purposes, which differs from most investment companies.

Though MLPs are exempt from federal taxes, a fund investing in MLPs will be subject to tax on the income this fund generates. Such taxes will reduce an investor’s return. Although, Global X MLP ETF expects that a portion of the income it receives from MLPs may be treated as tax-deferred return of capital, the risk still remains. MLP units can also be affected by macroeconomic and other factors affecting the stock market in general, uncertainty and adverse movements of interest rates, investor sentiment towards MLPs or the energy sector, and the general level of volatility.

Investment Thesis

Quarterly payouts with strong yield and the prospect of substantial capital gains make this fund very attractive. Three-fourths of MLPAs total holdings generated a return in excess of 26 percent during the past 12 months, and this enabled MLPA to grow by 21 percent. This fund should also be attractive for recording positive total return due to its strong yield, when the price growth was negative.

Thus, MLPA is an appropriate fund for income-seeking investors as well as strongly bullish investors wishing to speculate on the energy industry. However, these investors have to encounter excessive commodity risk, concentration risk, and high volatility due to the very nature of its portfolio. Thus, risk-averse investors may stay away from this fund.