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.

What's Hurting MLPs
Jay Hatfield, co-founder and president of Infrastructure Capital Advisors, and portfolio manager of the InfraCap Active MLP ETF (AMZA), said the sector is "tainted by these upstream MLPs, and that's made investors extremely nervous, and has affected the sector negatively."

Because upstream MLPs are closely tied to oil production, they're more likely to get hurt in the drop in oil prices.

Emily Hsieh, director of operations at Alerian, says the issue in 2015 is that people are not necessarily sure how long oil prices will remain at current levels.

"The fear now is that crude prices will stay where they are, and MLPs won't grow anymore," she said.

The income that MLPs generate still makes them attractive, particularly now, says Dan Heckman, national investment consultant for U.S. Bank Wealth Management. The yield spread between MLPs and the 10-year U.S. Treasury note has widened to as much as 500 basis points, versus the historical average of around 300 bps.

"We think the higher-quality MLPs will do fine over a longer-term cycle," Heckman said, adding that he believes MLPs are starting to bottom.

There is some debate as to whether any interest-rate hike by the Federal Reserve will pinch MLPs. Some argue the Fed won't raise rates high enough to entice yield-loving investors. But in late August, Barron's cited comments by Jeffrey Gundlach, founder of DoubleLine Capital, who said MLPs will suffer under a rate hike because of the leverage some MLPs use.

Phil Blancato, chief executive officer of Ladenburg Thalmann Asset Management, with $2.2 billion under management, says that despite MLPs being underwater, his firm is sticking with the investment. He still likes MLPs from a portfolio diversification standpoint, and that they can be a "solid dividend payer in a portfolio." He has a small allocation to the MLPX.

Blancato says the U.S. energy outlook is still positive, as energy infrastructure in the U.S. is vastly underserved and that demand in the U.S. and globally remains up, even with sluggishness in the global economy. Further, earnings for midstream MLPs remain solid, with all of them still paying dividends.

He would change his mind if the U.S. slipped into a recession and true energy demand fell, Blancato says. A sustained drop in crude oil prices would also give him pause.

"I think that producers in the U.S. are profitable north of $30 a barrel. Our opinion is, even with crude at six-year lows, U.S. producers are profitable here because of the efficiency of the fracking technology. That said, there's still room for the bloodletting to continue," he said.

Chuck Self, chief investment officer of iSectors, says investors should at least "have a toe in the water" for MLPs, noting that "the market has priced in a lot of pain."

What might be working against MLPs is that—until the late August equity sell-off—the stock market was focused on growth, rather than value, he says. Given the sector's volatility, he would recommend no more than 5% for a portfolio allocation.

Morningstar's Goldsborough says that given that only a handful of MLP ETFs are even five years old, one should consider the risk of investing in a sector so young.

"It's always more interesting to see how funds behave across a full market cycle. That's certainly an issue for MLPs," he noted.

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