A recent SA article ("Kinder Morgan Vs. AMLP", 1/2/14) asserts superior risk and return characteristics for the Alerian MLP ETF (AMLP) compared to Kinder Morgan (KMP), a major player in the MLP industry. This article seeks to highlight three logical flaws in that article, and asserts that for many investors the conclusion is in fact the opposite, Kinder Morgan, or similar large and financially strong MLP, would be the superior investment. Others on SA have argued that directly holding MLPs has additional tax advantages, but we will focus solely on these three arguments here:
- Three year timeline is inadequate and leads to false conclusions
- Bull-market focus fails to account for recession performance of approach
- Bull-market focus leads to underestimated volatility
For some investors Kinder Morgan, or a similar security, would be a superior holding:
- The largest and most financially strong MLPs perform better in a recession
- AMLP is a basket of MLPs including low-quality and higher risk securities
- Low-quality and higher risk securities are inappropriate for many investors
Timeline is Inadequate: The trouble with the previous article begins with the focus on three years of historic data. That short timeline is completely inadequate as it reflects the performance of MLPs in a nearly uninterrupted bull market. What are the top three things that work in a bull market? Risk taking, risk taking and risk taking. What kills you in a recession? Risk taking, risk taking and risk taking. Focusing on such a short timeline is inadequate as most investors have timelines which will include periods of both economic expansion and recession. What is needed is a more careful analysis using some proxy for the AMLP approach which estimates performance in a past recession.
Recession Performance of MLPs: Luckily a very good proxy exists for estimating the hypothetical performance of AMLP in the recession year of 2008 (i.e., before AMLP existed). That proxy is the "Alerian MLP Index" (AMZ) on which AMLP is based. Note that there is a modest performance delta between AMLP and the Alerian MLP Index, in large part due to the fact that the index contains 50 securities while AMLP holds 26 and seeks to emulate rather than duplicate the index. The performance delta has varied plus or minus 200 bpts over the last three years, a rather large tracking error, but not our concern today.
According to the data provided by Alerian, their index declined (41.5%) in 2008. That was surprisingly bad, and actually much worse than the S&P 500's (37%) decline that year. Now if we adjust that price decline by Morningstar's average "Oil & Gas Midstream" distribution yield for 2008 of 9.8%, an investor would still have faced a total return of (31.7%). Another estimate can be put together using a naive application of today's AMLP allocation-percents to today's constituent list and produces a rough estimate of a (28%) total return for 2008. That gives two estimates in the (28%) to (32%) range with a probable error estimate of plus or minus two percent. So let's go with an estimate of a (30%) decline in 2008 using the AMLP approach. This estimate seems both fair and useful.
Using that estimate for 2008 would have AMLP doing somewhat better than the 500, but a (30%) loss would still be devastating to retirees and other investors seeking income and low-volatility. The key question is: how would the AMLP approach have done compared to Kinder Morgan in 2008? Kinder Morgan's total-return was a much more modest decline of (8.1%), or roughly one quarter of the decline suffered by those who followed the AMLP approach. So in a year in which volatility and downside really mattered with the S&P 500 down (37%), the AMLP approach was down (30%), and Kinder was down only (8%). No one can seriously suggest that Kinder is "higher risk" than AMLP after looking at the 2008 data. The flaws in using three-year volatility and beta measurements to rate and select MLP securities is obvious after looking at recession data from 2008.
You get a much different picture of the beta of the securities compared to the S&P 500 by looking at 2008 as well. Kinder suffered only 22% of the S&P 500's decline, while the AMLP approach suffered 81% of the S&P 500's decline. Put another way, Kinder declined 78% less than the S&P, while AMLP declined a slender 19% less than the S&P. The AMLP approach was better than the market, but not much of improvement compared to just holding Kinder. In this case, the single-security approach beat the pants off the "diversified" approach.
One could argue that Kinder's beta relative to the S&P 500 was 0.22 in 2008, while AMLP's was 0.81. Both are less than the market's beta (1.0), but miles apart. Whichever statistic you focus on, this is still a stark contrast to the previous author's assertion that Kinder's beta and volatility are and will be higher. In the bigger picture of the full economic cycle, the beta and volatility are in fact considerably lower for Kinder.
Lower Quality & Higher Risk: During a recession, the financially strongest firms generally do the best and the financially vulnerable firms struggle. Some may even face bankruptcy during a downturn as borrowing becomes harder and glowing growth prospects flicker or expire without easy money. Thus it is perfectly logical that in a major decline like 2008, a financially strong firm such as Kinder would decline only (8%) while many weaker MLPs declined by (20%), (40%) or even (70%).
Although the constituents of AMLP's underlying index do vary (12% turnover, Morningstar), the table below shows that the current constituents' total-return in 2008 varied from (8%) to (69%). This indicates that this basket of MLPs contains a wide range of quality and financial strength in the underlying securities. The market unflinchingly revalued these securities based on their potential to borrow and deliver promised-growth during the biggest crisis in our lives. Financial strength mattered.
Annual Total-Returns for AMLP Top-15 Holdings
Enterpr Prod Ptnrs
Kinder Morg Ptnrs
Magellan Mid Ptnrs
Energy Transf Ptnrs
Plains All Am Pipeline
Markwest Eng Ptnrs
El Paso Pipeln Ptnrs
Sunoco Logist Ptnrs
Targa Resc Ptnrs
Access Midst Ptnrs
Western Gas Ptnrs
During a bull market, companies like Kinder Morgan are not likely to keep up with a basket of securities which include some highly leveraged and thus riskier growth stories. Here is the part of the story that is missing, that by adding those to the basket you change the performance characteristics of the basket and it comes to behave much more like the equity indexes. I don't deny that going down (30%) is better than going down (37%) as the 500 index did in 2008, but suggest that many investors came to MLPs looking for both high predictable dividends, and for the kind of financial strength and predictable revenue that means a security drops less than the market, in this case way less than the market. Going down (8%) when the market goes down (37%) is a rare and extremely valuable characteristic. After all there will be another economic recession, and another market decline. We get those every few years with surprising regularity.
Lower Quality Inappropriate for Many: Behavioral finance has highlighted the human fault of making bad financial decisions under stress. Plus the portfolios of investors tend to get more conservative with age because they may not have time to rebuild a portfolio hit by a 30% or 40% decline. Therefore many risk adverse investors will find a place in their portfolios for individual MLPs such as KMP, which demonstrated extremely low market correlation in past times of crisis (e.g., 0.22 in 2008). These investors will enjoy high dividend distributions and sleep well knowing they hold solid business with high recurring revenue and strong financial positions that will endure through the ups and downs of the market.
Author is long Kinder Morgan and holds KMP and other MLPs in managed accounts.