MLPs: Too Good to Go On?

From aiCIO's June issue: Leanna Orr looks at the explosion of MLPs and asks if they can continue to outperform.

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“What’s happening in the US energy business is really terrific, virtually for everybody,” Blackstone chairman and CEO Steven Schwarzman told a public pension board in January. “With fracking, we are going to be energy self-sufficient in the next eight years. It is an immense change and will affect nearly every American.”

It has already affected those Americans with assets in Alaska’s public retirement system, Ohio’s police and fire pension fund, and many others. Investors in master limited partnerships (MLPs) are a happy bunch. The publically traded vehicles—primarily used to fund non-renewable energy infrastructure like pipelines and refineries—have been beating equity markets and real estate investment trusts by wide margins since before fracking technology even took off.

“We started with a $200 million allocation, and have since added another $100 million,” says Gary Bader, CIO of the Alaska Retirement Management Board, which manages nearly $20 billion of state pension assets. Bader and his board selected the initial managers in October 2012 after a yearlong search. Fiduciary Asset Management and Tortoise Capital Advisors have together turned $200 million into $281 million—a 40% return in less than a year. Bader says his team is comfortable with the current size of the allocation, “although we hope the investments will grow themselves. We have been very happy with the MLPs.”

Indeed, $1,000 invested in AMZ (the leading MLP index) in 2003 would be worth $5,141 as of the end of March. In real estate investment trusts, it would have grown to $3,231. Despite commodities’ boom-and-bust reputation, the MLP index gained 17.8% annualized over the last ten years, with a Sharpe ratio of 0.95. In contrast, the S&P 500 returned 8.5% over the same period, with a ratio of 0.42.

In short, MLPs are killing it, and have been for at least a decade…which rouses skepticism in several top institutional consultants.

“Master limited partnerships are still a relatively small, narrowly defined, and concentrated asset class. Accordingly, it is unrealistic to conclude that MLPs will continue to deliver the outsized returns of the last 10 years,” JP Morgan’s latest missive on the subject warns. Andrew Brett, a senior research analyst at institutional consultancy NEPC who published a recent paper on the vehicles, is similarly cautious. “If you’ve held MLPs for the past 12 years, you would probably be very happy with them,” he says. “But there is always regression to the mean-type risk, and you did see a bit of that last year.”

Brett and NEPC’s CIO Erik Knutzen both see opportunity in the US energy sector for institutional investors, but argue that MLPs are just one way to access that market. “We view MLPs as part of a broader exposure to a natural resources sector that we think will grow, given the game-changing hydrocarbon revolution in the United States,” Knutzen says. But while everyone seems to agree that the broader energy infrastructure sector shows promise for long-term growth, MLPs may not be the ideal vehicle for institutions looking to access it.

MLPs’ tax advantages are a major draw for retail investors, which have traditionally dominated the space. For institutions that are already tax-exempt, however, the legal structure may cause a filing headache without boosting one’s bottom line. NEPC’s research paper also pointed out that MLPs have shown a modest positive correlation to equity markets, which is expected to increase dramatically during periods of serious market stress. “Our preferred strategy is direct investing through private partnerships,” Knutzen says. “MLPs can complement those.”

The Ohio Police and Fire Pension Fund’s board didn’t consider going direct when it approved a 5% ($600 million) allocation to master limited partnerships in December 2012. Executive Director John Gallagher is comfortable with that. “Obviously the education required to go direct would have been a hurdle,” he says. “In mid-2012, the board authorized a search process. We wanted to find and use active managers who are experts in that field-ones who really, really know the sector.”

Back in 2010, the now-$13 billion fund moved to a risk parity approach to balance exposure among investment classes and strengthen the portfolio against varying market environments. Wilshire Associates, its investment consultant, completed an asset-allocation study and suggested the board take a look at MLPs to gain exposure to the growing domestic natural resources industry. “Wilshire felt the MLP sector had grown to an institutional-sized market and would fit with the risk parity approach,” Gallagher recounts. The board originally looked at allocating 8% of its portfolio, but settled on 5%. Internal pension staff and their consultants shortlisted nine potential managers, made site visits, and hired three in February: Harvest Fund Advisors, Salient Partners, and Tortoise Capital Advisors. Gallagher’s verdict: So far, so good.

“We’re in this for the long haul, and are hoping to reinvest the quarterly distributions with our managers,” he says. “There are new IPOs coming onto the market every day. The asset class is pretty well established now—and it’s only going to grow.” —LO

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