Although Master Limited Partnerships (MLP) have sort of flown under the radar of many investors, over the last couple of years they are beginning to be “discovered” by more and more investors, as well as fund companies looking to profit in this area as well. With an annual total return of 15.5% since 1995 and current yields in the area of 6% it is easy to see why. Let’s take a brief look at what MLPs are and why they have become more popular of late.

MLPs are companies that operate in the transportation, processing, refining, storage, marketing and production of minerals or natural resources. There are essentially four areas of natural resources operations that fall into the qualifications to operate as an MLP:

• UPSTREAM – Natural Gas, Oil & Coal reserves & drilling.
• MIDSTREAM – Oil & Gas pipelines, storage, & transportation.
• DOWNSTREAM – Refineries, transportation by rail, truck or boat.
• OTHER – Timber, Geothermal Energy, Fertilizers, etc.

The majority of MLPs are in the energy sector. Many own and operate pipelines primarily for natural gas, oil and propane; they transport the resources from one place to another. They effectively operate as “toll collectors” that collect a “toll” from oil and gas producers who use the pipelines.

MLPs operate as a publicly traded limited partnership whose shares of ownership are referred to as units. It combines the tax advantages of a partnership with the liquidity of publicly traded stock. It also does not pay tax at the corporate level but, rather, at the unitholder (shareholder) level. To qualify for this favorable tax treatment, 90% of their income generated must come from what the IRS terms as qualified sources, which includes producing, processing or transporting natural resources. Although MLPs do not have a set requirement to distribute a certain percentage of their income to maintain their tax status, they do as a matter of policy distribute a large percentage of their current operating cash flow to unitholders. This differs from Real Estate Investment Trusts (REITs) which are required to distribute at least 90% of their ordinary income to shareholders to avoid corporate-level taxation.

Comparison of the Alerian MLP Index (in black) to the S & P 500 over the last 5 years

(The chart does not include dividends, which would make the difference even larger)

Why MLPs Are Getting More Attention?

As mentioned in the opening paragraph, the 15.5% annualized return since 1995 is one reason, but other reasons include:

Qualified Dividends - Most distributions qualify for 15% dividend income tax treatment.

High Yields – In this current low interest rate environment, it is tough to find attractive yields on income producing securities. Currently many MLPs are yielding north of 6%.

Price Appreciation – Most MLPs, in addition to their attractive yields have also had very good price appreciation as well.

Reduced Correlation with the Stock Market – MLPs have historically only had a modest correlation with the stock market. This has made them a good portfolio diversifier.

Predictable and Growing Cash Flows – Since many companies that operate in this space are effectively “toll” collectors, their revenues are generally fairly stable, since it is predicated on the amount of resources that flows through the pipelines, not so much the price of the natural resource.

Risks of Investing in MLPs

Even though MLPs have a lot of good things going, to get those kind of returns is not without some risks as well, such as:

Higher Interest Rates – Higher interest rates generally have an adverse effect on income securities such as bonds, REITs and MLPs. In a rising interest rate environment, MLPs may be subject to price weakness (although in the current rising rate environment we have been in since November 2010, MLPs have done very well). However, MLPs may perform better than bonds since the companies have the ability to grow their cash flow base and increase their distributions.

Tax Complexities – For many people, the K-1 tax form that individual MLPs issue each year can be daunting (see below), and a reason to not invest, however, as shown below, there are plenty of alternative ways to invest in this market, and avoid this issue.

Volatility - Even though MLPs have reduced correlation with the markets, they still can go through periods of extreme volatility. In the credit crisis of 2008, MLPs were hit hard along with virtually every other asset class. Part of the reason was that a lot of large hedge funds had significant exposure and were forced to liquidate which put further pressure on prices. However, during this time very few MLPs cash flows and distributions were affected.

Tax Law Changes– MLPs currently enjoy an attractive tax structure, with higher tax rates, and the government looking for ways to increase tax revenues, there is always the possibility that these advantages could be taken away in future tax legislation which could have an adverse effect on the sector. On an individual level, with current tax laws the 15% qualified dividend exemption is set to expire at the end of 2012, so this could reduce the tax efficiency of MLPs.

Ways to Purchase MLPs

You can purchase MLPs in one of five ways:

Individual Company – There are about 80 individual companies that trade on the stock exchanges that you can purchase. Some of the larger companies are Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), and Magellan Midstream Partners (MMP).  Since you are now a limited partner, you are entitled to distributions and share price appreciation or depreciation that may occur. As long as you continue to be a unitholder you will annually receive a fairly complex tax form called a K-1, which you will use to report your income received from the MLP during the tax year. If you happened to own 5 MLPs you would receive 5 K-1’s. This form can be cumbersome, and it will make your tax return a more complicated, but if these companies continue to do well it can be worth it. You also have to be careful buying these companies in your IRA, because they generate what the IRS calls Unrelated Business Taxable Income (UBTI), and if you have more than $1,000 of this during a year, the amount over $1,000 is taxable to you in the IRA. If you are looking to avoid the hassle of the K-1 form, the following four options are also available:

Closed End Mutual Funds – There are a handful of closed end mutual funds, which invest in MLPs. Funds such as Fiduciary/Claymore MLP Opportunity Fund (FMO), & Tortoise Energy Infrastructure Corp (TYG) , that have been around for some time. Closed end funds also trade like stocks, but can trade at a premium or discount to the underlying holdings. The advantage of buying a closed end fund is that you get a diversified portfolio of MLPs, run by an investment manager, receive a 1099 tax form (much simpler) instead of a K-1, and can hold in an IRA without any tax problems. The disadvantages are some closed end funds can have rather high fees, and some may use leverage to enhance returns and yields, but can also make them more volatile.

Mutual Funds – Within the last year or two there have been a couple of fund companies that have started traditional mutual funds that invest primarily in MLPs. The advantage of these over closed end funds is that they do not use leverage, and have lower expense ratios. So far the new mutual funds have shown similar results to the closed end funds that have been around for some time. The mutual funds also issue 1099 tax forms instead of K-1s and are IRA friendly as well; since no UBTI is generated. Steelpath runs 3 funds that each takes a slightly different approach. Another company called Cushing began in October 2010. There are also more companies that are in the process of launching funds or have just done so recently.

Exchange Traded Funds (ETFs) – ETFs have become very popular with many investors because of their ease of use and flexibility compared to mutual funds. ETFs will have the same benefits as the traditional mutual funds (maybe even lower expense ratios), but with the flexibility of an ETF that trades like a stock. They will also issue 1099s, do not use leverage, and would also be IRA friendly. Alerian is a company, which has for years kept a benchmark index of MLPs; they started an ETF in 2010 as well called the Alerian MLP ETF (AMLP) which is based on this index. All of the other funds listed above are actively managed funds compared to the ETF which is a passive index of MLPs.

Exchange Traded Notes (ETNs) – ETNs are very similar to ETFs in the way they trade, but are actually a debt security in that it combines the features of an ETF with a bond. The returns of the ETN are based upon the performance of a market index and the value of the ETN can be affected by not only the market index it tracks but also the underlying credit of the firm that issues the ETN, since it is an obligation of the issuing company in much the same way as a bond. JPMorgan has issued an ETN based on the Alerian MLP Index (AMJ) that has performed very well since its inception in 2009.

Where Are We Now?

MLPs have had a very nice run the last few years, and still make a very compelling long term investment for a diversified portfolio. However, some indications are that, you may consider waiting for a correction in the market before committing new money to this area. Currently, the yield on the Alerian MLP Index (AMZ) is right around 6%, which is near the low end of the range of yields that MLPs have enjoyed. The record low was 5.37% in 2007, before the 2008 swoon.

Another valuation metric to strongly consider is the yield spread between the MLP Index and the yield on the 10 year U.S. Treasuries. In July 2007, the spread was as low as a few basis points, and by the end of 2008 the yield spread was about 1200 points (12%). Currently in February of 2011, the yield spread is around 260 basis points (2.6%), which is also getting close to the low end of the historical range. Historically, when the yield spread gets narrow, MLPs have run into some headwinds, so it is important to be cognizant of the yield spread.

Overall, the MLP sector can be a very lucrative market sector to invest in; with attractive yields, good tax efficiency, the chance for price appreciation, and a modest correlation to equities, they can make a good addition to a diversified portfolio.

Disclosure: Nothing in this article constitutes investment advice or recommendation as to the suitability of any product or security mentioned above.

Even though the stock market has been doing very well as of late, many investors still have vivid memories of the stock market crashes of 2000-2002, and 2008. Many people wonder what they can do to help reduce the volatility of their portfolio. We have previously discussed using options to reduce risk, now, we turn our attention to another strategy that can provide good portfolio diversification, reduce volatility, and enhance overall portfolio returns. That strategy is Managed Futures.

What are Managed Futures? Essentially, it is a trading strategy that may involve going long or short futures contracts in areas such as:

• Metals – Gold, silver, platinum, etc.
• Grains – Soybeans, corn, wheat, etc.
• Equity indexes – S & P 500, Dow Jones, etc.
• Soft Commodities – Cotton, coffee, cocoa, sugar, etc.
• Foreign Currencies – U.S. Dollar, Swiss Francs, etc.
• U.S. Government Bonds – Futures on Treasury Bills

The strategy has been used successfully by large endowments such as Harvard & Yale for many years, as well as successful Hedge Funds. For smaller investors, though, it has been more difficult to access this strategy. However, that has changed over the last few years as there are mutual funds available now that offer this strategy such as the Rydex Managed Futures Strategy Fund or the Altegris Managed Futures Strategy Fund. Generally, these mutual funds will use a trend following strategy to go long or short the particular future, and to stay consistent with the index which could be either the Altegris 40 Index mentioned below, or the Standard & Poor’s Diversified Trends Indicator (DTI).

The key advantages of using Managed Futures as a portfolio diversifier are:

• The very low correlation to stocks and bonds.
• The ability to profit in any kind of market environment.
• Can enhance returns and reduce overall portfolio volatility.
• Generally, have produced consistent long-term returns (see below).

Some disadvantages:

• The strategy in a mutual fund will have a higher expense ratio than most traditional mutual funds.
• Not really the most tax efficient strategy so is generally better utilized in tax advantaged accounts such as an IRA.

The information below is obtained from the Altegris website and gives a general view of how an index of Managed Futures has performed the last 10 years versus US Stocks.

Performance Statistics: Managed Futures vs. US Stocks

July 2000 – June 2010

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Managed Futures represented by Altegris 40 Index; US Stocks represented by S&P 500 TR Index. Source: International Traders Research (ITR). The referenced indices are shown for general market comparisons and are not meant to represent the Fund. The Fund is new and has no performance history.

So, even though the Managed Futures Strategy has been around for 30+ years, it is a more recent addition in mutual funds. The long term results have been very good, and the benefit of reducing the volatility and increasing the diversification in your portfolio make them worth a look.

Many people think of stock options as a risky investment strategy used mostly by highfalutin Wall Street types with millions to burn. While it’s certainly true that you can get yourself into trouble with an ill-advised option position, options can also be used to effectively reduce portfolio risk. One option strategy that can do this is called “collaring”.

Collaring uses options to greatly reduce the risk inherent in a stock position by putting a limit on the possible losses, with the trade off of limiting the upside. The most basic use of an option to reduce downside risk in your portfolio is the purchase of a Put. When you buy a Put, you are buying the right, but not the obligation, to sell your stock at a certain price.

First, a couple of definitions:

Put Option -A Put option gives the owner of the Put the right, but not the obligation to sell stock at a certain price by a certain date. A single Put option contract covers 100 shares of the underlying stock

Call Option -A Call option gives the owner of the Call, the right, but not the obligation to purchase stock at a certain price by a certain date. The person who sold the Call is obligated to sell his stock at the strike price of the option if the Call owner exercises his right to do so. Like a Put option contract, a call option contract covers 100 shares of the underlying stock.

Strike Price – The strike price is the price noted on the option that dictates whether the owner of the option is able to exercise his rights.

Example:

You own 1,300 shares of Amgen (AMGN) that has a current value of $55.50 a share, thus your holding is worth $72,150 currently.

One of your primary concerns is capital preservation, so you’d like to protect your portfolio against a big drop in the value of your AMGN stock. You’ve decided that you’re not comfortable with the thought of that stock dropping much below $50 a share. Let’s assume that right now that it’s May. You learn that there are Puts available for AMGN. Some of the put options available are the October $50 Puts. Purchasing these puts would give you the right to sell your AMGN stock at $50 a share between now and the date the put expires in October in the event that the market price of AMGN is below $50/sh. So you go ahead purchase 13 put contracts for $177.00 each or a total cost of $2301.00. [$1.77 (cost per share) x 100 (number of shares per contract) x 13 (number of contracts purchased) = $2,301]

Now that you have purchased these Put options, you not only have the right to sell AMGN for $50 between now and October, you also have the right to sell the Put options themselves. If the price of AMGN stock goes down, the value of your Puts goes up. If the value of AMGN drops between now and October, the value of each Put option will increase by about a $1 for each dollar below $50. Thus, if we are near the third Friday in October (options expire on the third Friday of the month), and the value of AMGN is $40, each Put option price should be near $10 per share, causing the value of your puts to increase to $13,000. [$10 x 100 (number of shares per contract) x 13 (number of contracts) = $13,000] Now you have a choice to either exercise the option and sell the stock at $50 a share, ($50 x 1,300 = $65,000) or keep the stock and sell the options for $13,000, which offsets your loss on the stock below $50 a share.

By just owning Puts, your upside is still unlimited, but your downside is limited .One drawback of this strategy is that Put contracts come at a cost. These costs can add up over time and hurt portfolio returns. However, there is a way to offset the cost of the “put” insurance. This can be accomplished by selling Calls on the AMGN stock. Selling Calls generates income which can be used to pay for the Puts. This is what is meant by the term collaring, which is simply the practice of buying Puts and selling Calls on the same stock. Here is an example:

Since the cost of the put protection alone can be very expensive over time, we can sell Calls to implement the collar strategy. Using the same example from above with AMGN trading at $55.50 a share, we learn that the October Calls with a 60 strike price are selling at $1.72 a contract. By selling Calls we can generate $2,236.00. [$1.72 (price of call per share) x 100 (shares per contract) x 13 (number of Call contracts sold to cover all 1300 shares owned) = $2,236]

By selling this Call with a strike price of 60, we are obligated to sell our shares of AMGN to the buyer of the Call if the shares of AMGN rise above $60 a share between now and October. However, we have offset the cost of the Put protection with the proceeds from the sale of the Call options, leaving a net cost of $65 for implementing the collar strategy. [$2,301 (cost of Puts) - $2,236 (proceeds from selling Calls) = $65] The stock is now protected if it falls below $50 a share, but its upside is limited up to $60 a share.

Now 3 things can happen:

• The price of AMGN can stay within the range of $50 to $60 until October. If this happens, both the puts and calls expire worthless, and we would consider initiating another collar to keep protection in place. The $65 is considered a cost of insurance.
• The price of AMGN, could fall below $50 a share between now and October and we can either sell the shares at $50 or sell the put option (which has now increased in value) to offset any loss resulting from the stock’s decline.
• The price of AMGN could rise above $60 a share between now and October, in which case the stock can either be called away (meaning we will have to sell it at $60 a share) or we can repurchase the calls we sold. If we repurchase the calls that were sold, this cost would be offset by the rise of the stock above $60 a share, so we have still limited the gain on the stock to $60 a share, but have retained ownership of the shares of AMGN.

Example: AMGN is at $63 a share near the expiration date in October, and we decide we still want to hold onto the shares of AMGN instead of having them called away at $60. The value of the Calls is now around $3.00 a share, so $3 a share x 100 shares per contract x 13 contracts = $3,900 to buy the calls back, but the 1300 shares of AMGN are also up $3,900 ($63 – $60 = $3 a share x 1,300 shares = $3,900), so the net effect is we only participated in the gain in AMGN up to $60 a share during the time the options were held.

We can also use different time frames, and use options with expiration periods longer than just a couple of months. This is generally what we would do in order to avoid having to make frequent adjustments to the collar.

Tax Effects – Quite often, options expire with no value. Depending upon which side of the transaction you were on, this results in a gain or a loss. Investors are required to recognize the gain on the sale of Puts in the year they expire, but any losses resulting from Puts cannot be recognized until the stock is sold. Also, whenever options are exercised (which results in the sale of the underlying stock) there will likely be a gain or a loss on the sale just as there is in any normal stock transaction.

Although the Collaring strategy does produce some additional taxes, they are fairly modest and can be avoided by implementing the strategy in an IRA account. Where that isn’t possible, the tax consequences have to be taken into consideration and weighed against the benefits of the strategy.

In order to introduce you to what may be a new concept, we have simplified this discussion of option collaring. We intentionally omitted a detailed discussion of how options are priced and what factors affect option prices. Also, the example we used here did not consider commissions, which are generally not much of a factor. It is also important to also note that the Collar can be implemented for both stocks and market indexes. Collaring is considered a conservative strategy that does a good job of preserving capital over time. Collars allow you to have exposure to the stock market while limiting the downside to a tolerable, predetermined amount. The trade-off is that you give up some upside potential. For investors concerned about preserving wealth while allowing for modest growth, collaring options can be a very effective strategy.

If you are a client of ours, you have probably heard us at one time or another talk about Monte Carlo Simulation (or Monte Carlo Analysis). The term itself is kind of strange sounding, and the first time you hear it you’re bound to conjure up images of either the famous casino in Monaco or a two-door Chevy coupe. Believe it or not, the former image would be more correct, but I’ll explain that later. Monte Carlo simulation is a calculation method used in a wide variety of fields ranging from physics, weather forecasting, architecture, and of course financial planning. Its purpose is to estimate the probability of a certain outcome using random input numbers. In most cases, thousands or even tens of thousands of calculations are made in order to produce the result. The advent of today’s high-speed computers has made it possible for these calculations to be done quickly and has made it possible for small companies like ours to use Monte Carlo simulations.

Have I lost you yet? Let me try to bring you back by telling you how we use Monte Carlo analysis. Most of our clients are very interested in knowing if they are on track to live the lifestyle that they desire. Whether they are retired with their earning days well behind them, or they are just entering their peak earning years, Monte Carlo analysis is one of several tools we can use to provide them with some guidance on what their future might look like. In its simplest application, we can us it to calculate the probability that someone’s nest egg will last a given number of years assuming that person is drawing on that nest egg at a given annual amount. Monte Carlo analysis will produce that probability using projected market returns that reflect the investment composition of the nest egg. But instead of simply applying the portfolio’s average historical return, the analysis will arrange the annual returns in a random fashion so that one year the portfolio might return 6% and the next year it might return -3%. (It is this random generation of results that led the creators of Monte Carlo simulation to name it after the casino where roulette is so popular.) The possible range of investment returns applied to the simulaton will depend upon the risk profile of the portfolio. More aggressive portfolios will have a wider range of possible returns, while the range on more conservative portfolios will be narrower. To provide a more reliable figure, the calculations are done thousands of times. The idea is to simulate what happens to the nest egg by running multiple scenarios using the entire range of expected investment returns.

Now, the previous example doesn’t really reflect a real-life situation for most people. First of all, almost no one spends the same amount of money every year. Also, the composition of your portfolio in most cases changes as you get older to a more conservative asset allocation. Fortunately, we are able to account for these things in our analysis. Modern software also allows us to take other real-life variables, like inflation, into account, because after all inflation can have as much impact on the success of a plan as investment return can. Better versions of the Monte Carlo analysis allow the user to factor in the effects of bad timing of returns to account for the fact that a couple of bad years in a row can have a larger or smaller impact on the success of a plan depending on when they occur. Perhaps the most serious limitation of Monte Carlo is its inability to effectively account for high impact events which are outside the realm of what is thought to be possible, otherwise known as “Black Swan” events. The market crash of 2008 certainly qualifies as such an event. Its difficult to build these types of events into the Monte Carlo model, but after 2008 software vendors are making an effort.

If the simulation for a particular person indicates the probability of success at say 65%, we may consider a number of steps to take in order to increase the odds. Usually those steps will include more saving, less spending, or perhaps working a little longer than they had planned. Another option would be to consider increasing the risk profile of the portfolio by adding more exposure to stocks, but we are usually hesitant to ask anyone to step out of their risk tolerance comfort zone.

Monte Carlo Simulation is not perfect, but we believe it is a useful tool in financial planning to offer some guidance on the probable success of a plan. It would be great if it could predict the future, but it can’t, and we make certain to tell our clients about its limitations. For instance, we cannot predict tax rates with any degree of certainty, and attempting to apply probabilities to tax rates does not make much sense mathematically. Yet tax rates have a definite impact on any financial plan. Also, Monte Carlo simulation does not take into account human behavior. After a particularly good year of investment returns, many people would likely spend a little more money the following year than they normally would, and this is not taken into account. Ultimately, the percentage number that a Monte Carlo simulation spits out is only as good as the data that’s entered to arrive at that percentage. In order not to create unrealistic expectations, we run the simulations using conservative investment returns and liberal inflation numbers.

Finally, we know that financial plans must be viewed as living organisms that are constantly changing and evolving. Whenever Monte Carlo simulations are used in financial planning, they should be revisited regularly to account for real-life changes. They also must be viewed for what they really are; a useful but imperfect guide that should never be relied upon as the sole analysis tool of anyone’s financial plan.