Many MLP CEF Investors Are Using The Wrong Benchmark - Are You?

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Includes: SRF, SRV, TYG
by: Alerian

By James Wang

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Today there are 95 publicly-traded energy MLP-access products on the market; a figure that nearly matches the number of MLPs [1] themselves. While having options is generally a good thing, having too many options brings up the paradox of choice [2]. So how do you objectively choose the best fund? Well, as an indexing company, we'd tell you to compare it to a benchmark.

You may ask, "but isn't the Alerian MLP Index (AMZ) already the gold standard for MLP benchmarks?" and you'd be right. (Clearly, we're biased.) However, with the abundance of MLP investment funds, comes a variety of different product structures and nuances. We've launched the Alerian MLP Closed End Fund Index (AMCI) to address a particular subset of those products: closed-end funds (CEFs) which elect to be taxed as C Corporations for federal tax purposes.

So what are closed-end funds and what makes them special? Well, to start with, CEFs were the first type of pooled investment products to enter into the MLP space, with Tortoise Capital Advisors launching the Tortoise Energy Infrastructure Corp (NYSE:TYG) in 2004. Today CEFs make up about 20% [3] of all MLP investment products by AUM.

As partnerships, MLPs have certain tax complexities that reduce their efficiencies in pass-through investment products. While traditional mutual funds, CEFs, and ETFs may pass on all gains/losses to their investors, funds whose holdings comprise more than 25% in MLPs must elect to be taxed as a C Corporation [4] for federal income purposes. This means that there's an extra layer of corporate taxation that shaves off approximately 35% [5] of all gains before it even reaches the investor. Yeah, it kind of stinks, but unfortunately those are the rules, and it's the only way to construct a pure-play MLP fund.

C Corp CEFs, however, have the ability to mitigate some of that tax drag through the use of leverage. Furthermore, since the funds are "closed" in construction, unlike open-end funds (ETFs, Mutual Funds), the capital they have is permanent, allowing them to hold less-liquid investments. A potential downside (or upside, if you time it right) to the structure is that these funds may trade at a significant discount or premium to their net asset value.

To make things even more complicated, there are a number of CEFs with the words MLP in their title, but they merely hold 25% of their fund in MLPs (to get around the C Corp rules). Those types of funds are referred to as "RIC-Compliant funds" and may have significantly different investment characteristics. For the purpose of the AMCI, RIC-Compliant funds are excluded, as it would not allow for an apples-to-apples comparison.

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The Alerian Closed End Fund Index's construction is relatively straight-forward. Today, there are 21 MLP C Corp CEFs on the market, with AUMs ranging from $19 million to nearly $2 billion. All of these funds are included and equal-weighted within the AMCI. Historical data was generated by backtesting the index back to 2004, when the first MLP C Corp CEFs were launched.

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Examining the total return performance of the AMCI in the chart above, you'll notice that it lags significantly behind the AMZ. This is expected and really showcases the effect of the C Corp tax drag. Even though CEFs use leverage [6] to offset some of this drag, that leverage is only helpful on the way up. On the way down, leverage exacerbates losses. Although in the past three months, the AMCI has outperformed the AMZ, over periods of a year or longer, it has significantly underperformed.

yield

When looking at the yield of the AMCI, you'll see that it's also significantly higher than the AMZ. While some CEFs may focus their investments on higher-yielding MLPs, it's not necessarily a universal trend, with leverage playing a larger role in boosting yields.

One important note is that since this index is equal-weighted, small funds have an outsized influence on index performance while larger funds may be under-represented when compared to an AUM- weighted index. Unfortunately, the smallest funds are also the worst-performing in the index.

When looking at the price return of the AMCI as of 3/31/16, the following data points stand out.

  • 12 of 21 funds have outperformed the AMCI on a trailing one-year basis
  • 11 of 13 funds have outperformed the AMCI on a trailing three-year basis
  • 7 of 8 funds have outperformed the AMCI on a trailing five-year basis
  • 4 of 4 funds have outperformed the AMCI on a trailing 10-year basis

How is it possible that the majority of index constituents outperformed the index for the 3-, 5-, and 10-year history? Unfortunately, two funds [7] dragged the entire index down by hundreds of basis points [8]. Although it's unfortunate that these funds had such a negative impact on index performance, it also showcases that there can be large disparity between the best- and worst-performing active managers.

In the end, Alerian exists to equip investors to make informed decisions about their MLP investments. There are multitudes of MLP-related funds in the marketplace today and the most important thing is to know what you own. If you've already made the decision to go with an active manager and are comfortable with the pros and cons of C Corp CEFs, we hope that the AMCI better equips you to make an informed decision with your investments.

2016.05.19 2:30PM CST - Edited to correct phrasing in paragraph 4 and footnote 4.

Footnotes

[1] There are 118 energy MLPs as of the end of April.

[2] As psychologist Barry Schwartz has said "Autonomy and freedom of choice are critical to our well-being, and choice is critical to freedom and autonomy. Nonetheless, though modern Americans have more choice than any group of people ever has before, and thus, presumably, more freedom and autonomy, we don’t seem to be benefiting from it psychologically."

[3] Over $9B in aggregate AUM as of February 29, 2016

[4] This is due to the American Jobs Creation Act of 2004. Previously, MLPs could not be held at all in such funds without making a corporate tax election.

[5] The federal corporate tax rate is 35%, but state taxes could push the fund tax rate higher.

[6] The amount of potential leverage can be found in each fund's offering documents, but typically a fund’s maximum debt leverage is 33% while its equity leverage is 50%, as governed by the Investment Company Act of 1940.

[7] The Cushing MLP Total Return Fund (NYSE:SRV) fell over 87% from its inclusion on December 21, 2007 to March 31, 2016 while the Cushing Energy Income Fund (NYSE:SRF) fell over 93% from its inclusion in the index from June 15, 2012 to March 31, 2016.

[8] Theoretically, if we were going to cherry-pick this index and remove SRV and SRF, the annualized 10-year total return performance would have jumped 220 basis points from +1.7% to +3.9%. The 5-year annualized performance shows similar results, jumping nearly 370 bps from -7.8% to -4.1%.

Disclosure: © Alerian 2016. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.

James Wang is the Director of Data Analytics at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Mr. Wang conducts quantitative and statistical analyses in order to bring to light historical and emerging trends in the asset class. He also oversees the firm's efforts to efficiently integrate and utilize technology in its brand management activities. Prior to Alerian, Mr. Wang was an Associate in the Equity Research Division of Raymond James & Associates Inc, where he constructed financial models for energy infrastructure MLPs and published comprehensive research reports to discuss his findings. Mr. Wang graduated with a Bachelor of Science in Biomedical Engineering and a minor in Management from the Johns Hopkins University Whiting School of Engineering.