Alerian MLP Index Concludes Stellar Decade

In the last decade (January 1, 2001 to December 31, 2010), the MLPs had one of the best gains ever for any industry group. Below are the beginning and ending values for the Alerian MLP Index along with the previous record reached in 2007.

Date -- AMZ -- AMZX - Yield
12/31/00 - 131 - 191 - 8.8%
07/13/07 - 342 - 750 - 5.4%
12/31/10 - 363 - 1026 - 6.2%

The Alerian MLP Index, AMZ, almost tripled, very impressive considering how many quality companies had little or even negative appreciation in this decade. Dividend Aristocrats (with a minimum history of 25 years of annual increased dividends) such as General Electric (PFE) and Bank of America (BAC) reduced dividends during the recession, resulting in their removal from this elite group. AMZX, the comparable index including reinvested income, had a superb performance, rising more than five times the original value, with an equivalent compounded annual growth rate of more than 18%.

An alternative measure of performance is to begin with the record value reached in July 2007 (what turned out to signal the first wave of the financial market meltdown). The index is up 21 (6%) while the index including reinvested income rose 37% (equivalent to a compounded annual growth rate of 13%). Gold is one of only a few investments with higher growth rates since then.

The business model of MLPs has remained intact during the financial meltdown and recovery. Funds were raised to finance expansion of pipelines and other fixed assets while many companies had difficulty securing financing.

In 2009, a number of closed end funds and mutual funds were started to track MLP indices or concentrate on MLP investments. They give an averaging effect for the investor but do not have tax hassle (and lack tax benefits) associated with owning MLP units. AMJ is one of the oldest tracking funds (almost two years old). For AMJ, 10 shares approximate the value of AMZ with a current yield of almost 5%. Dividends are paid from distributions received net of fund expenses. There are a number of tracking funds but one, MLPL, needs to be singled out for its high risk. This fund's goal is to double the yield and capital appreciation (capital losses are also doubled). But added potential gains bring added risks. Doubler funds have poor records of tracking their base funds over the long term. In addition higher interest rates on borrowed funds, used to achieve doubler effects, will reduce net income for MLPL.

There are other ways to participate in MLP growth by purchasing shares in corporations. Kinder Morgan (KMR) and Enbridge Energy (EEQ) are stocks created by these MLPs. Shares track the comparable unit prices and pay stock dividends based on the distributions to the respective units, making them very tax efficient.

The rapid rise for MLPs in the last two years could cause them to run into headwinds in 2011. Higher values bring lower yields. The yield on the index has fallen to 6.2%, the lower region in its 15 year history. MLPs remain yield investments and low yields suggest topping in market prices. In the last two months the index was sluggish after reaching new record levels, while Treasury rates rose sharply (1 percentage point for the yield on the 10 year Treasury bond).

The long term outlook for the industry remains excellent, but it will be difficult to replicate the performance of the last decade. Growth rates could slow. Derived investment income from the index has risen at an annual rate of 5½% in the last three years which may be representative of the rate going forward, implying investment income of 38.50 in 2020. Today's low yield of 6.2% projects an ending value of 620 for the index, a 71% gain in this decade. Different assumptions will change the ending value, but it's logical to assume that the growth rate of income will slow for a more mature industry. Existing unit holders ought to be happy with this growth but new investors should be prepared for slower growth of distributions and higher yields which would further limit growth of unit prices (and the index).

Disclosure I am long GE, PFE and AMJ.