On November 8, Seeking Alpha published what I believe to be a quite hazardous recommendation of Fiduciary/Claymore MLP Opportunity Fund (NYSE:FMO) standing alongside what I previously believed, and continue to believe, is the singular, uniquely merited relative valuation reversion-to-the-mean Closed-End Fund trading candidate, Eaton Vance Risk Managed Diversified (NYSE:ETJ). My assessment of ETJ's unique reversion-to-the-mean potential had been published as an Investment View on October 28.
For this and other reasons, qualitative assessments of apparent quantitative regression-to-the-mean Closed-End Fund candidates have certainly been on my mind of late. Today, I will highlight the reasons for which I believe FMO may be the most hazardous of all potential Closed-End Fund relative valuation regression-to-the-mean trading candidates. In short, I believe there are glaring weaknesses in the conclusions of "Joe Eqcome's" Nov. 8 article that recommends FMO.
Know Market Advantage and Disadvantage
Most of us don’t have a crystal ball and don’t want to depend purely on luck. To rationally anticipate being the smartest side of any trade, an investor needs intrinsic conviction they know a security’s dynamics better than the party on the opposite end of the trade from (or to) whom they are buying (or selling). Such is an application of trading discipline. For example, if I have doubt that I have superior appreciation for a security, in choosing to trade I would likely be at a disadvantage. Thus a detailed and thorough thesis is vital.
As easy as it may be to qualitatively screen out high-premium funds, the observation of a premium or discount is simple, and may be known by all market participants. Premiums on funds like CFP, CLM, CRF, and GUT are often supported by the vicious cycle of short sellers who lack any insightful analysis having to cover their shorts.
The worst of all longs and the best of all savvy short positions are those subjected to unrecognized facts… facts that are not flashing in fluorescent green lights like a huge and long sustained premium. These are the types of observations I have attempted to write about, nearly exclusively. If a security’s flaws are so obvious that the security has already been beaten down in the written work of even unsophisticated Closed-End Funds observers, one should seek to learn what they don’t know and consider the upside risk of a short covering rally as highly relevant.
I am actually not short FMO. This is not because FMO’s intrinsic investment prospects aren’t terribly inefficient or problematic. Rather, while its deficiencies are not so terribly obvious as a high premium for anyone to observe in a newspaper, a competent CEF market expert should be well aware of the rationale to be short FMO. I believe to have higher standards for shorting a security of FMO’s upside risk profile. So, what is that relatively simple rational to be short?
FMO Structural Inefficiency
While better known as a Closed-End Fund, FMO is technically taxable as a C-Corporation. Like other Closed-End Funds (e.g. KYE, KYN, NTG, TYG, TYY), Mutual Funds (MLPAX, MLPOX, MLPDX, MLPZX, MLPFX, MLPTX, CSHAX, CSHCX, CSHZX), and the ETF (NYSEARCA:AMLP) that invest in MLPs, its Net Asset Value (“NAV”) should account for its tax burden. I documented one demonstration of the financial effect in Nuveen’s MLP & Strategic Equity Fund Inc (NYSE:MTP), upon it writing down its NAV by $1.05 per share overnight. Chuck Epstein, an award-winning financial writer who has written by-lined articles for over 50 financial publications and clearly a proponent of progressive change in the asset management industry, also just covered the C-Corporation product phenomenon among other important MLP investing topics.
In short, the C-Corporation structure generally constrains NAV performance to less than 70% of the long-term performance of underlying securities. So, assuming positive long-term returns if the asset class proves to have investment merit over time, FMO’s NAV performance is highly likely to underperform even a random sample of the MLP asset class constituent. I am not advocating the throwing of darts as there are numerous single security hazards in a sector cluttered with conflicts of interest. Significant Incentive Distribution Rights (“IDRs”) to an MLP holdings’ General Partner may be a very concerning indicator of potentially conflicted interest.
Rather, the C-Corporation structure of an MLP-focused single security investment wrapper is far less efficient than direct ownership. Therefore, in addition to inferior NAV returns, FMO may prove to be subject to insufficient market demand for its product shares, and thus be assigned a wide discount by Mr. Market over time. I’m surely not advocating to own MLP ETNs (AMJ, MLPN, MLPI), which themselves have distribution challenges and in their manufacture create new credit risk.
I love Closed-End Funds generally, but Closed-End Funds investing in MLPs may prove upon widening discounts in addition to incomplete asset class participation even worse than AMLP. To be clear, that is not a compliment to AMLP. And what appears to me worse than MLP Closed-End Funds generally, is FMO in particular. Here’s why:
FMO Governance History
FMO recently did a secondary offering, priced at $19.36, and after an $0.81 underwriting discount added $18.55 in proceeds, before expenses, to the fund. Such a governance choice for a Closed-End Fund increases Assets Under Management (“AUM”), and clearly benefits those who earn assets under management fees. The transactions are expensive to the Closed-End Fund, whose shareholders own it, and indirectly bear that expense in a Fund’s NAV performance. The additional supply of shares can have an effect on the supply/demand curve immediately. The possibility that such governance actions may reflect a Governance interest in maximizing AUM in spite of the detrimental effects may cause Mr. Market’s longer term pricing dynamics to reflect broader assessments of the fund's governance.
No Critique of FMO Portfolio Managers
While I may not identify with whether a C-Corporation Structure for an MLP investment vehicle should ever exist, I am in no way blaming passing judgment on the management of FMO. While there are some holdings in the portfolio which I personally find to be subject to Conflict of Interest risk with which I’m uncomfortable, I am sure they do their due diligence in portfolio selection. The pool of investable MLPs is not huge, and perhaps they are open to some things I am not open to in desire of having more diversification than my own 16 Direct MLP holdings.
The people behind FMO very well may be great people. They have a great challenge in outperforming the asset class to such an extent to make up for the C-Corporation tax classification. The same is also true of AMLP, the index ETF, and other MLP-focused Mutual or Closed End Funds of course.
Futher, the author who contributed a recommendation for FMO may have his reasons, whatever they are, for not perceiving FMO to be hazardous and recommending it. Perhaps he expects the relative valuation to change in a day or a week, and that the long-term structural issues won’t matter in the interim. Although I have confidence in my own discipline, I am far from perfect. And, everything that I assess is subject to being wrong. I won’t walk away from that, and I won’t dodge merited critique. The Seeking Alpha venue benefits from having some extraordinary intellect among its members, and to the extent others comments make me smarter, I thank them. I never wish to stop embracing critique. I never wish to stop learning.
Disclosure: No positions in securities mentioned. Author is long 16 MLPs directly in an account licensed to Covestor’s MLP Direct Ownership Model, and short one unreferenced MLP Focused Closed-End Fund in accounts licensed to Covestor’s Long/Short Opportunistic Model and Covestor’s Pure Short Opportunistic Model. Dan Plettner and Covestor are both cited in the work of journalist Chuck Epstein, to which this article refers. Covestor is a Registered Investment Advisor (“RIA”) licensing Dan Plettner's data to create models for its clients. In addition to receiving royalties from Covestor, Dan receives income for securities research. Dan is neither a Registered Investment Advisor, nor an employee of Covestor.