When MLP Is Spelled E-T-N

07/27/2010 11:41 am EST

Focus: FUNDS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, director of North American ETF Research for Morningstar, says an exchange traded note may be the best way to invest in master limited partnerships.

With a yield of more than 6%, JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) offers a better income stream than most bond or equity funds available today, and we think it still has ample room to increase its distributions over the years ahead.

Master limited partnerships, particularly those specializing in transporting and storing energy commodities, have been phenomenally strong performers by the standards of income investors—or any standards, for that matter.

Not only do virtually all MLPs provide current yields substantially higher than the market in general, but the best-run partnerships have been able to increase distributions faster than any comparable class of high-income securities.

While holding MLPs, investors have historically received a generous income stream—even greater than that of its utility-company cousins. Furthermore, the lack of institutional ownership in MLP units has caused the indexes’ fluctuations to act somewhat independently of other equity markets.

Pipelines are by far the cheapest way to transport liquids and gases over long distances. Because any new pipeline needs to justify itself based on economic need, few face direct competition from their own kind. And once a pipeline is built, it tends not to require much significant and costly maintenance, so it spits out gobs of free cash flow.

As long as volume holds reasonably steady, a liquids pipeline is almost a perfect hedge against inflation, while providing yields much higher than an investor can get with Treasury Inflation-Protected Securities.

This ETN tracks the Alerian MLP Index, which is a market-cap-weighted and float-adjusted index of 50 prominent energy MLPs. The constituent companies are screened for minimum quarterly distributions, so the holdings remain focused on the largest distribution providers. The average market-capitalization holding is around $3 billion, giving this fund a small-cap and value bias.

Fees aside, the principal drawback of an ETN is that it represents an unsecured obligation of the bank behind it. The investor isn’t taking just the risks associated with the MLP industry, but also the credit risk of the issuer. So long as the backing bank remains solvent, this structure provides superb index tracking in a tax-efficient vehicle. In fact, we think MLP ETNs make more sense for some investors than owning MLPs outright or in the exchange traded fund (ETF) or closed end fund (CEF) wrapper.

This ETN charges 0.85% per year in annual expenses, which we think is reasonable given the targeted exposure the fund provides. (It close Monday above $33—Editor.)

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