INVESTMENT PERSPECTIVE | DECEMBER 2013 Master Limited Partnerships (MLPs)— A Brief Review Laurie Carroll Managing Director, Index Specialist In the current environment, where investors are searching for yield, Master Limited Partnerships (MLPs) can provide a steady stream of dividend income. Interest in MLPs has increased in the last few years, but many investors still know little about the product and its potential benefits. The majority of MLPs are in the energy sector, where there are more than 100 publically traded entities with a market capitalization of over $400 billion. MLPs are limited partnerships that are publically traded on a security exchange, thus they provide the security tradability and liquidity of a common stock with the tax treatment of a partnership. The tax treatment is an important distinction allowing the partnership structure to avoid corporate income tax at both state and federal levels. Investor interest in the structure has increased over the years due to the generally high dividend distributions, currently over 5%, and that many MLPs operate in the energy industry. MLPs operate capital intensive businesses that typically generate revenue streams at either a fixed (with annual inflation linked increases) or federal regulated rates. Why should investors consider an allocation to MLPs? Over the past 10 years, the S&P Master Limited Partnership (MLP) Index has outperformed most equity benchmarks, with an annual return of 14.98% vs. 7.57% for the S&P 500®, and 9.64% for the Russell 2000®. Using a fund vehicle may be the most efficient structure for institutional investors to access the MLP sector. Figure 1: Total Returns (Annualized) As of October 31, 2013 Data source: Factset 10 YR 5 YR S&P 500® Energy 3 YR S&P 500® Utility 1 YR S&P 500® Russell 2000® S&P MLP YTD 0 5 As of September 30, 2013 Data sources: eVestment and Bloomberg 15 20 25 Returns 30 35 40 S&P MLP Index Russell ® 2000 Index S&P 500® Index S&P 500® Utilities S&P 500® Energy Dividend Yield 5.63% 1.59% 2.02% 3.96% 2.11% Standard Deviation 16.92 19.69 14.66 13.07 21.13 Sharpe Ratio 0.79 0.38 0.40 0.65 0.61 Correlation to S&P 0.48 0.93 1.00 0.56 0.69 Figure 2: Comparing Indices Standard deviation and Sharpe ratio based on monthly data over 10-year period. 10 Tracking error versus the popular S&P 500 benchmark is also a consideration for institutional investors. Using Barra, we calculate that on an ex-ante basis the S&P MLP Index will mis-track the S&P 500 Index by 10.77%. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Confidential and Proprietary – Do Not Duplicate Copyright © 2013 Mellon Capital Management Corporation 1 Master Limited Partnerships (MLPs)—A Brief Review Structure and Features of MLPs MLPs are concentrated in the energy sector. Congress included in the Revenue Act of 1987 rules to define and limit the use of publically traded partnerships. To qualify for MLP status under Section 7704 of the Tax Code, a partnership must generate at least 90% of its income from what the Internal Revenue Service (IRS) deems “qualifying sources.” This generally limits MLPs to certain businesses related to the use of natural resources and energy. Cash flow is usually sourced from the production, processing, or transportation of oil, natural gas, and coal. Legislation in 2008 expanded the qualifying income to include certain renewable energies and industrial CO2. One of the major reasons for a company to choose the MLP partnership structure rather than incorporation is that shareholders in a corporation face double taxation. Corporate shareholders receiving earnings as dividends, first pay taxes at the corporate level and then at the personal level. In the MLP partnership, only the individual owners, the “unit holders,” are subject to taxation. Like Real Estate Investment Trusts (REITs), MLPs pay out the majority of their cash flow to shareholders as they are a pass-through legal entity. There are two classes of MLP owners. One is the limited partners and the other is general partners. Investors in MLPs are considered limited partners. Limited partners have no involvement in the partnership’s operations. The general partners manage the day-to-day operations of the partnership. An MLP technically has no employees, so all services are provided by the general partners. In most cases, the general partner is paid on a sliding scale, receiving a greater share of the earnings distributions as the limited partners’ distributions increase. MLPs generally pay their investors through quarterly, required dividends divided among the limited and general partners. Dividends and Taxes Dividends in an MLP structure are called distributions. Dividend yields and their growth are the main elements affecting MLP performance. Typically there is a minimum quarterly distribution. Many MLPs offer attractive yields, making them a popular investment for income-oriented investors. While tax efficiency is one of the unique features of the MLP structures, other differences include: • • • Investors receive IRS K-1 instead of the usual 1099. The annual K-1 form lists the unitholders’ proportionate share of the MLPs income, gain, deductions, losses, and credits. Individual investors file state taxes in each state in which the MLP operates. Distributions could trigger Unrelated Business Taxable Income (UBTI) for tax-exempt entities. Each unitholder is responsible for paying their share of the partnership’s income taxes. Many large unit holders are more likely to reach the thresholds that would require an investor to file tax returns in various states in which the partnership operates. Distributions are taxed at the marginal rate of the limited partner; there may be no tax advantage to claiming the pro-rated share of the MLPs depreciation when the investments are held in a tax deferred account. Investing in MLPs may have unwanted tax consequences for tax-exempt vehicles because they may generate UBTI if it is determined that the income is considered income earned from businesses activities unrelated to the entity’s tax-exempt purpose. If a tax-exempt organization generates UBTI in excess of $1,000 per year, the organization is required to document this with the IRS and may be required to pay taxes on UBTI in excess of this amount. Larger institutions may be able to offset this income from other investments. Some pension plans have decided they do not have to pay taxes on UBTI. Institutional investors mainly access MLPs through collective vehicles and funds. This is generally limited to qualified employee benefit plans and certain government plans. Investors should consult their tax advisors before investing. Confidential and Proprietary – Do Not Duplicate Copyright © 2013 Mellon Capital Management Corporation 2 Master Limited Partnerships (MLPs)—A Brief Review Risks MLPs are subject to certain risks just as with any security: • • • • • Regulatory Risks- If the IRS changed its tax treatment for the MLP structure, partnerships may not enjoy a pass through of taxation to their partners in order the double taxation. Also, the revenue stream from oil and gas could be affected by changes in government regulations. Interest Rate Risk- Rising rates would increase the cost of capital which could result in lower distributions. Liability Risk- Unitholders typically have no liability, similar to shareholders in a corporation. Creditors may have the right to seek the return of distributions made to unit holders if the liability in question arose before the distribution was paid. Potential Unrelated Business Taxable Income (UBIT). Valuation Risk- Historically, MLPs at times have underperformed in the short-term in periods of rising interest rates. The maximum drawdown for the S&P MLP Index during the ten year period ending September 2013 was 42.64%. Investment Option-EB Daily Valued MLP Index Fund An index fund is an effective solution to gain exposure to the MLP sector. Mellon Capital’s Quality Indexing approach aims to replicate the risk and returns of an index while at the same time minimizing costs and preserving value for clients. In December of 2010, Mellon Capital launched the EB Daily Valued MLP Index Fund. This collective trust fund provides eligible (ie, not subject to UBTI and non-erisa government investors) institutional investors an option for diversified exposure to this segment. The Fund seeks to match the performance and overall characteristics of the S&P MLP Index in a risk-controlled environment. The S&P MLP Index is designed to provide exposure to leading MLPs that trade on major U.S. exchanges. The index includes both master limited partnerships and publically traded limited liability companies (LLCs), which have a similar legal structure to MLPs and share the same tax benefits. As a pioneer in indexing, we believe it is beneficial to construct a fund around transparent objectives, and an investable benchmark like the S&P MLP Index. An energy based MLP index fund provides an investor with an access to this sector in a flexible and cost-efficient manner. Figure 3: EB Daily Valued MLP Index Fund Characteristics and Performance As of September 30, 2013 Performance results greater than one year are annualized. The benchmark is the S&P MLP Index. Data sources: S&P and Mellon Capital Figure 4: Top Ten Holdings As of September 30, 2013 Data source: Mellon Capital Characteristics Fund Dividend Yield 5.24% Beta 1.00 Number of Stocks 56 Mean $-Weighted Cap $18.9 bn Median Capitalization $3.1 bn Price/Earnings Ratio 25.56 Price/Book Ratio 2.67 Benchmark 5.24% 1.00 56 $18.9 bn $3.1 bn 25.56 2.67 Enterprise Products Partners L.P. Kinder Morgan Energy Partners, L.P. Plains All American Pipeline, L.P. Energy Transfer Equity, L.P. Magellan Midstream Partners, L.P. Energy Transfer Partners, L.P. MarkWest Energy Partners, L.P. Kinder Morgan Management, LLC ONEOK Partners, L.P. Buckeye Partners, L.P. Total Gross Performance Fund % Benchmark % QTR -0.4 -0.46 YTD 22.63 22.48 1 Year 18.66 18.44 Inception 15.76 15.57 Inception 12/22/10 Fund % 15.22 7.84 7.73 6.12 5.92 4.35 3.77 3.06 3.05 2.99 60.5 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Confidential and Proprietary – Do Not Duplicate Copyright © 2013 Mellon Capital Management Corporation 3 Master Limited Partnerships (MLPs)—A Brief Review Conclusion MLPs have generated strong returns and have been a popular investment over the last few years. MLPs provide an alternative structure for investors to access a potentially higher income stream than is currently available in many equity and fixed income investments. Investors in MLPs would also gain exposure to the expanding U.S. energy sector. Finally, many index vendors have excluded MLPs from their flagship indexes due to the additional tax treatment for investors. Exposure to MLPs may complement an investor’s asset allocation as an alternative income asset. Appendix Figure 5: Summary—S&P MLP Index Characteristics Index As of October 31, 2013 Data source: S&P 69 MLPs in the Energy Sector and Utilities Industry Methodology At rebalancing a stock can have a w eight not more than 15% in the index and all stocks w ith a w eight greater than a 4.5% float-adjusted market cap are not allow ed, as a group, to exceed 45% of the index Weighting and float adjustm ent m ethodology Market cap w eighted adjusted for free float, w hile applying single stock and concentration limit capping to the index constituents Dom icile All publically traded partnerships w ith listings on the NYSE, the NYSE MKY, the NASDAQ Global Select Market , the NASDAQ Select Market, or the NASDAQ Capital Market Market Capitalization Companies w ith float-adjusted market capitalization above $300 million Liquidity requirem ents Companies must have 3-month average daily value traded above $2 million Maintenance Annual in October. No additions are made to the index between rebalancings Confidential and Proprietary – Do Not Duplicate Copyright © 2013 Mellon Capital Management Corporation 4 Master Limited Partnerships (MLPs)—A Brief Review Special Notes • Please refer to the Schedule A for the Fund (and for each other fund such Fund invests in) for important additional information. • Characteristics and data shown are for a representative account and are provided as supplemental information. • The list of top ten holdings should not be considered a recommendation to purchase or sell a particular security, may represent only a small percentage of the entire portfolio and the securities purchased for advisory clients, and may not remain in the portfolio at the time you receive this report. You should not assume that investments in the securities identified were or will be profitable or that decisions we make in the future will be profitable. • Please see Performance Disclosures for important information about externalization of transaction costs for collective funds. EB DV MLP Index Fund Performance Disclousre Statements Disclosures This does not constitute investment advice. You should keep in mind that no allocation plan can always ensure a profit or protect against a loss. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Past results are not indicative of future performance and are no guarantee that losses will not occur in the future. Future returns are not guaranteed and a loss of principal may occur. Charts and graphs herein are provided as illustrations only and are not meant to be guarantees of any return. The illustrations are based upon certain assumptions that may or may not turn out to be true. This presentation does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation. This material (or any portion thereof) may not be copied or distributed without Mellon Capital’s prior written approval. Statements are current as of the date of the material only. Performance is expressed in U.S. dollars unless noted otherwise. Performance results for one year and less are not annualized. Many factors affect performance including changes in market conditions and interest rates and in response to other economic, political, or financial developments. The active risk targets and information ratio targets shown in this presentation are the long run ex-ante targets. The active risk levels and information ratios may be higher or lower at any time. There is no guarantee that the active risk targets and information ratio targets will be achieved. The following provides a simplified example of the cumulative effect of management fees on investment performance: An annual management fee of 0.80% applied over a five-year period to a $100 million portfolio with an annualized gross return of 10% would reduce the value of the portfolio from $161,051,000 to $154,783,041. The actual management fee that applies to a client’s portfolio will vary and performance fees may apply. The standard fee schedules for Mellon Capital’s strategies are shown in Part II of Mellon Capital’s Form ADV. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Past results are not indicative of future performance and are no guarantee that losses will not occur in the future. Future returns are not guaranteed and a loss of principal may occur. 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Mellon Capital has provided global multiasset solutions for thirty years. Our precise understanding of world markets, coupled with our fundamentals-based and forward-looking analytical methods are the foundation for tailored client solutions. Our investment capabilities range from indexing to alternatives with the infrastructure and skill to transact in all liquid asset classes and securities. 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