by Lisa Barr
Energy and natural resource master limited partnerships (MLPs) offer numerous advantages—high yields, stable income and immunity to volatility in commodities prices, for starters. Yet, despite the staggering growth in the asset class in recent years, MLPs still haven't caught on with the general investing populace as a whole.
Texas-based Swank Capital LLC aims to change that with its suite of Cushing Funds, including the upcoming Cushing MLP Premier Fund, an open-ended mutual fund based on the Cushing 30 Index, a fundamental-based index whose launch we covered last year. (An ETN, MLPN, based on the index already exists.)
Daniel Spears, a partner at Swank Capital, is no stranger to MLPs. With 14 years' experience in investment management and investment banking within the natural resources sector, Spears is an expert in energy and infrastructure MLPs. He also currently serves as portfolio manager for the Swank MLP Convergence Fund, L.P.
Recently, HAI Associate Editor Lara Crigger spoke with Spears about why MLPs are outperforming the market, his outlook for 2011 and who the target market is for the Cushing MLP Premier Fund.
Crigger: The S&P 500 is up about 7 percent year-to-date, while the Cushing 30 Index is up over 26 percent. So why are MLPs so vastly outperforming the greater stock market this year?
Spears: I think people are learning the benefits of the distribution growth of the asset class, and its strong fundamentals. New capital has been coming into the market, and there's been new awareness of people understanding the benefits of investing in MLPs, due to the strong fundamentals underpinning the underlying businesses.
MLPs are essentially "toll-road" businesses, transporting crude oil, natural gas and refined products from the supply centers to the demand centers. So it's a very stable, utility-like business. MLPs have strong distribution growth coupled with a strong current income yield. When you've got companies raising debt at below 1 percent, people are starved for yield.
But the outperformance of the Cushing 30 Index really comes back to the index being a fundamental-based index, versus a market-cap-weighted index.
Crigger: Why does that make a difference?
Spears: Anybody right out of school can create a market-cap-weighted Index. But to create a fundamentally based index, you have to really understand the drivers behind stock performance. That's distribution growth, strong balance sheet, strong competitive position, good management team, and so on. That's where our fundamental research comes into play, when we developed those criteria for the formula for the Cushing 30.
Crigger: What's your outlook for 2011?
Spears: With QE2 coming into play, I think you're going to see a low-interest-rate environment. We've always told people that MLPs should look at midteens returns—you get anywhere from 5-7 percent current income, and then 5-7 percent distribution growth.
Crigger: We've seen a bevy of new investment products around MLPs enter the market recently, including the Credit Suisse Cushing 30 ETN (NYSE Arca: MLPN). Most have attracted significant assets very quickly, even though investor awareness about MLPs as a whole remains relatively small. What's driving the inflows?
Spears: I think a lot of people looked at the closed-end funds, but that's a small universe for investors. Our ETN based off our index is about $85 million right now, and we've seen increased flows as people realize the benefits of our index over others.
Then you do have an ETF out there, too. But given the tax drag it has, it will underperform the index by that tax drag. All the investment products available are all taxed as a C Corp, because of the limitations of the RIC rules of 25 percent of the investment being in MLPs. So they all have to choose to be taxed as a C Corp. That means for investors, as the stock goes up, the fund has to accrue for deferred tax liabilities at the federal and state level.
Crigger: Have these ETPs that have grown so big so fast attracted too much attention, and priming for a pullback? Are they becoming too popular too soon?
Spears: I wouldn't say so. I think you have to look back on the development of the REIT market in the mid-90s. A couple years ago, you had a lot fewer MLPs. This year, we've had new segments arise; we had two new IPOs this year in the natural gas storage sector.
So just like in the REIT sector, where you went from apartment REITs and shopping mall REITs, you're having MLPs segmentizing themselves into different areas. I think investors have to understand what they're investing in, and choose if they want passive exposure or active exposure. Many people seeking yield are attracted to the Cushing 30 because they just want passive exposure to the asset class.
Crigger: With MLPs becoming so popular—and the government always looking to tax somebody—are you concerned the IRS may revisit its stance on MLP ETNs someday soon?
Spears: No, because it's just the same type of structure as a REIT. It's passing through income. The person who owns it ends up paying the taxes eventually.
Crigger: Swank Capital is launching the Cushing MLP Premier Fund next week. Tell me a little about it.
Spears: The Cushing 30 MLP Premier Fund is our open-ended MLP mutual fund product. We're launching it because there are a lot of segments in the investing populace that want exposure in an open-ended format versus a closed-ended format. With an open-ended mutual fund, you're trading in and out of the fund daily at NAV. But with a closed-end fund, you can be purchasing at a premium or discount. With an open-ended format, you get daily liquidity at NAV.
So for the Cushing 30 MLP Premier Fund, as we've demonstrated with the Cushing 30 Index, we've got the fundamental research here, and we understand how to look for relative value opportunities to drive current income for investors.
Crigger: What kind of investor would this fund be for?
Spears: It's really a decision on the person's own position. In an ETN, the dividends are taxed as ordinary income. When you have an open-ended mutual fund, because of the characterization of the underlying distributions from the MLPs, it looks like a lot of the income will be return of capital, versus ordinary income. That's an expectation, though. We've just started, so I can't promise that for sure.
Crigger: But do you foresee interest mostly from retail investors or institutional investors?
Spears: Each investor has his or her own criteria, so we really think that it will be people who are searching for an uncorrelated asset class with strong fundamentals and current income. We're seeing increased interest from institutions, but really, I think it will be the individual investor looking for income options.