Diversify an Income Portfolio with MLPs ETFs | ETF Trends

Investors may consider incorporating energy infrastructure MLPs and related exchange traded funds to enhance an income-focused portfolio.

In the recent webcast, Beyond Oil: Finding Opportunity in MLPs, Stacey Morris, Director of Research, Alerian, touched upon the current demand destruction that has weighed on oil markets, pointing out that second-quarter estimated demand has fallen off 23.1 million barrels per day compared to the second quarter of 2019. Looking ahead, the significant increase in global oil inventories will take time to work down.

However, the oil industry’s midstream role in the energy value chain may be more insulated from the price volatility since this segment of the energy sector engages in gas processing, fractionation, storage, transportation, and crude oil gathering.

Moreover, these services are under long-term contracts. Master Limited Partnerships charge a fee for each barrel of petroleum or MMcf of natural gas transported. This covers smaller pipelines connecting wells to hubs or processing facilities for natural gas, which are more sensitive to production dynamics, along with Larger, longer pipelines that connect hubs or producing regions with end markets. These MLPs typically charge rent for third parties to use storage tanks.

As a way to help investors track these segments, Alerian has come out with the Alerian MLP Infrastructure Index (AMZI) and the Alerian Midstream Energy Select Index (AMEI).

The two Alerian indices have also exhibited a lower correlation to West Texas Intermediate crude oil price moves, with the AMZI showing a 0.56 correlation to WTI and AMEI showing a 0.65 correlation to WTI.

Investors who are interested in diversifying exposure to this segment of the energy market can turn to ETFs, such as the ALPS Alerian MLP ETF (NYSEArca: AMLP), which has been a popular way for investors to access the MLP space. Paul Baiocchi, Senior Investment Strategy Advisor, ALPS Advisors, pointed out that investors can directly invest in MLPs, but investors will have to deal with a K-1 form each year for tax purposes, along with increased risks associated with single security selection. Alternatively, one may consider MLP-focused funds that invest in MLPs, produce a 1099 tax form, historically provided a high level of income, and historically provided a high level of tax deferral – the total tax-deferral on distributions of AMLP since inception is 81.5%. However, potential MLP-focused funds investors should note that these funds are required to be taxed as a corporation, which may eat away at total returns.

Energy infrastructure funds like the Alerian Energy Infrastructure ETF (NYSEArca: ENFR) are structured as a regulated investment company, so they don’t come with corporate-level taxation. However, these energy infrastructure funds hold a maximum of 25% invested in MLPs while the rest is in midstream corporations, utilities, or other energy companies. Additionally, it may provide a more moderate level of income and tax deferrals. This type of fund also generates a 1099 form.

Baiocchi also argued that midstreams might offer more attractive yields and diversification benefits to a fixed-income portfolio. For example, AMZI shows a 12.16% yield, and AMEI has an 8.68% yield, compared to the 4.14% yield for REITs, 3.79% for utilities, 2.12% for the S&P 500 and 1.39% for bonds. Looking at the diversification benefits, AMZI has exhibited a 0.77 correlation to REITs, 0.52 correlation to utilities, 0.78 correlation to the S&P 500, and -0.02 correlation to bonds. Meanwhile, AMEI shows a 0.84 correlation to REITs, 0.56 to utilities, 0.80 to the S&P 500, and 0.02 to bonds.

“Midstream provides critical energy infrastructure while offering defensive energy exposure and attractive income,” Baiocchi said. “Company-level improvements leave midstream well positioned to withstand the current energy downturn, particularly the larger names. Fee-based cash flows and built-in contract protections provide some insulation from adverse movements in commodity prices.”

Financial advisors who are interested in learning more about master limited partnerships can watch the webcast here on demand.