Hard Landing For High Flying MLP Funds

October 12, 2015

{This article originally appeared in our October issue of ETF Report.]

Master limited partnerships were a darling of investors who wanted exposure to the U.S.' energy renaissance, or those looking for higher income—or both—but a tumble in crude oil prices and a stock market rout is leaving investors smarting.

MLPs, as these investments are known, focus on the U.S. energy sector and are usually classified in one of two ways: upstream MLPs, which are tied to energy exploration and production; or midstream MLPs, which focus on infrastructure, such as pipelines.

Pretty much any investment with the word "energy" in it is being punished right now. As of Aug. 25, the United States Oil ETF (USO | B-100), which delivers exposure to oil using near-month futures, is down 65% from its 12-month high, and crude oil futures prices are at their lowest level since early 2009.

The 12-month returns of the 27 MLP ETFs listed on ETF.com's website shows not a single one is positive. The best performer, the First Trust North American Energy Infrastructure (EMLP), is down 12.38% as of Aug. 25. The worst performer was the Yorkville High Income MLP (YMLP), down 53.53%. Meanwhile, the Alerian MLP (AMLP), the largest and most liquid MLP ETP, is down 19.40%.

It's All Relative
Paul Britt, senior analyst at FactSet, says a few things stand out when reviewing why some MLP ETPs are doing relatively better than others.

"The legal structure comes into play in the MLP space and the way you can access them through ETFs. The tax perspective also has an impact on performance," he noted.

There are two ways ETPs are usually structured to avoid tax complications in the MLP space. For ETPs that are set up as regulated investment companies and want to keep their tax pass-through status, their holdings in securities that issue a Schedule K-1 tax form are capped at 25%.

Those that invest more than 25% in Schedule K-1 securities are structured as C-corporations. These pay taxes at the fund level, so investors have a "watered down" exposure to the underlying index, Britt says. C-corporations pass on the reduced income to investors, who then pay their own taxes, so the same income stream is taxed twice. The taxes are expressed to investors as expenses.

This watered-down exposure helps in bear markets, he adds, which may explain why some funds are outperforming. However, in bull markets, these funds lag.

"In a bear market, it really has a very large impact, even before exposure to the nature of the security," Britt said.

EMLP's relative outperformance comes from the fact the fund is not a pure-play MLP. It's an actively managed fund that invests in North American energy infrastructure MLPs and LLCs, and it's structured as a traditional 1940 Act fund. The description from the ETF.com database shows EMLP includes "pipelines and utilities structured as C-corporations, Canadian firms that used to be royalty trusts, and unique institutional MLP shares issued by MLP affiliates."

Robert Goldsborough, fund analyst at Morningstar, agrees that the funds with relative outperformance have diversified holdings, such as the Global X MLP & Energy Infrastructure (MLPX), down 20.23%.

"Things that have done the best are not MLPs. That's the compelling story here," he said.

The worst-performing funds in terms of one-year return were the riskiest. There are those that doubled-down on MLP bets, such as the Etracs 2X Monthly Leveraged Long Alerian MLP Infrastructure ETN (MLPL), down an unsurprising 47.8%. Or, they may have focused on high yield, like YMLP, which was sold to Van Eck's Market Vectors—along with Yorkville's High Income Infrastructure MLP (YMLI)—earlier this year.

These high-yield funds are just another example of why income investors need to be careful about reaching for as much yield as possible, Britt notes.

Goldsborough says another factor affecting the worst-performing ETPs is size, with small-caps doing the worst. YMLP has an average market-cap weighting of $1.06 billion, and another underperformer, the Global X Junior MLP ETF (MLPJ), which is down 39.4%, has an average market-cap weighting of $1.5 billion.

That compares with the Global X MLP (MLPA), which is down 22.4% and has an average market-cap weighting of $12.95 billion, and AMLP's average market-cap of $12.2 billion, Goldsborough says.

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