Choosing The Right MLP Fund As Oil Slides

March 19, 2015

The state of the energy market today is the best of times and the worst of times for master limited partnership ETFs.

 

MLPs are vehicles that pass the income earned in some form of partnership directly to investors. By design, they can only be used for businesses where 90 percent or more of the revenue is being generated from qualifying activities, such as managing natural gas pipelines or storing crude oil. These are industries that generate steady income streams, but that also require large investments in infrastructure that need to be depreciated over long periods of time.

 

ETFs that invest in MLPs are hugely popular with investors looking for income generation, and for tax management tools. But when it comes to MLP ETFs, their returns can vary dramatically. They each respond differently to commodity prices, industry developments, the amount of leverage used by the MLPs, etc.

 

In the current environment, with crude down by roughly half since last summer and inventories nearing a glut as U.S. production nears all-time records, the dispersion between the best-performing MLP ETF and the worst-performing in the past six months is 30 percentage points. If you go back an entire year, the difference in total returns between the best and the worst nears 43 percentage points. 

 

Chart courtesy of StockCharts.com

 

Inside The Worst Performer

The Yorkville High Income MLP ETF (YMLP)—the worst-performing MLP ETF in the past year in a segment with 25 strategies—tracks an index of MLPs weighted in tiers based on their yield. The fund is structured as a C-corporation to get around the rule that open-ended ended funds can't hold more than 25 percent of their portfolios in MLPs. That structure means that distributions are taxed first at the corporate level before being passed on to investors.

 

By design, YMLP's yield-focused tiered weighting scheme boosts yield relative to the broader segment, but it also gives the fund a drastic small-cap tilt. That tilt has not paid off during oil’s recent plunge, as smaller names feel the pinch of falling energy prices faster than bigger companies.

 

The yield focus has also likely contributed to poor recent performance. Higher yield often goes hand in hand with higher risk from a total return perspective. Consider that YMLP is paying 13.06 percent in distribution yields due to its approach.

 

Still, YMLP’s yield is driven higher by its falling share price—much like with bonds, distribution yield goes up when prices go down. YMLP’s yield in dollars on a per-share basis has fallen since 2013.

 

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