MLPs offer attractive tax-deffered yields and total returns. MLPs have handily outperformed the S&P since 1996 and look to continue to do so. With the emergence of unconventional oil and natural gas plays in North America the sector is also in major growth mode. But most investors think that MLPs are higher risk – after all we’ve all been brainwashed into thinking that higher returns must come with higher risk. Turns out that nothing could be further from the truth. There is a ton of academic research that has disproved the higher risk equal higher return mantra. Today I want to specifically look at MLPs in terms of two risk measures, beta and maximum drawdown.
Lets start out beta. Beta is related to volatility/standard deviation but also encompasses correlation. Beta is defined as the ratio of asset volatility to the market volatility times the correlation of the asset to the market (more here). The market has a beta of 1. The basic premise is that assets with betas below 1 are less risky than the market and assets with betas above 1 are riskier than the market. You can find the beta of any stock in most stock quoting sites like Yahoo Finance (under key statistics page in the stock history section). If we look at the betas for MLPs over the last 2 years we get the following chart (source Credit Suisse):
The red line in the chart is the median beta of all MLPs in the Alerian Index. The median is 0.8 which means MLPs overall are 20% less risky than the market. The chart further breaks out MLPs betas by the various classes of MLPs. Propane (APU for example) and pipeline (KMP for example) MLPs are the least risky with betas of 0.6 and the MLP general partners are the most risky with betas of 1.2. This makes intuitive sense if one thinks about the stability of cash flows among the MLPs. For example, pipelines make their money of fee based services tied to long term volume based contracts where as the general partners make money off of their leveraged positions to the limited partner’s cash flows. The kings of low risk MLPs are APU and KMP with betas of 0.4 and 0.3 respectively.
Now lets consider a metric I often discuss on the blog, maximum drawdown. Max drawdown is the maximum peak to trough dollar loss in percent terms. So, from late 2007 to early 2009 when the S&P went from over 1500 to around 700, that represents a maximum drawdown of over 50%. I prefer drawdown over beta or volatility because it shows you what the dollar loss in your portfolio would have been over time. This is something that volatiltiy nor beta will do. And since the first rule of risk management is don’t lose money, maximum drawdown is a better measure of capital loss risk. I ran the maximum drawdown numbers for the S&P500 and the Alerian MLP index going back to the beginning of 1996. Here are the results which include all dividends.
The chart shows that since 1996 the S&P500 was significantly riskier than MLPs. The market had drawdowns of over 40% twice in this time frame, with an over 50% drawdown in the crisis, while the MLP index only has one, 40% during the crisis. Also, an important point is that the MLP index returns to break even faster than the market. This is due to their high dividends and the bear market protection that high dividends give you. During the financial crisis it took MLPs 30 months to return to their previous peak which it did by December 2009. The market still has not returned to its previous peak, it is still off about 14% from its October 2007 high. That is a 15 month difference and counting!
The biggest risk for investing in MLPs is a type of risk that is not quantifiable, e.g. political risk. The government could change the tax laws so that MLPs lose their tax advantaged status. The same holds true for REITs and BDCs. I don’t think that this is a significant risk for several reasons. First, MLPs represent an economically advantaged way to build out energy infrastructure in the US that I think the government wants to continue to promote. Second, there is no rampant abuse of the tax structure like there was in Canada where all type of companies were being incorporated as energy trusts even if they had nothing to do with energy. Third, the same law applies to REITs and I can’t see how REITs would be favored over MLPs in this type of tax structure. Having said all this, it is still a risk so I think this one reason why MLPs still trade at relatively high yields despite their superior fundamentals. Also
In summary, by the measures of beta and maximum drawdowns MLPs are less risky than the overall market and offer superior after tax total return prospects. Starting tomorrow MLPs kick off earnings season with KMP reporting after market close. I’ll be blogging about the earnings reports of the big cap MLPs during the coming weeks. Stay tuned.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.