Hedge Fund Era Ends, MLP Era Begins

by: Dana Blankenhorn

Every recovery, it seems, sees the end of one investing era and the dawn of another. The last decade was the era of the hedge fund. Computerization gave them birth. These privately held funds could afford the hardware and software power needed to get inside trades, using algorithms to score small returns many times over, creating fortunes.

But as fortunes were made, the game changed. Hedge fund managers became celebrities, players in the great game, and their CEOs became the face of Wall Street to many investors. People like Steven Cohen of SAC Capital and Bill Ackman of Pershing Square began using their insider knowledge to go after whole companies, not just positions. Their success in these efforts only inflated the speculative bubble around their funds, fueled by publicity from TV and various websites.

But every boom busts. Every market advantage is eventually copied and commoditized. Hedge funds' returns have been trailing the market the last few years. Och-Ziff (NYSE:OZM), for instance, is down over one-third from its 2010 high. Fortress Investment (NYSE:FIG) only recently took out its 2011 highs, and has yet to even approach its 2008 levels.

Publicity and hubris are behind Cohen's indictment and Ackman's stupid bet against Herbalife (NYSE:HLF), which was matched on the other side by other hedge fund managers who cared less for the merits of the case than the idea they could crush a competitor. It's one thing to get rich off the nickels and dimes that fall through the cracks of the market's floor. That's a good business. It's another thing to become the big swinging celebrity who thinks he can do no wrong. It's a great way to lose peoples' money.

So what's replacing hedge funds? Master limited partnerships. MLPs are hot for two reasons. One, they throw off huge dividends, as you can see by this chart. Second, they're in investment areas that are most favored by the current recovery: real estate and oil and gas. Real estate is hot because this recovery is depending so heavily on monetary policy rather than fiscal policy. Creating money rather than spending money means there's more money around, so assets improve even when no work is getting done.

For MLP investors, this means your investment can increase in value even while the partnership is constantly extracting income in the form of dividends. America First Tax Exempt Investors (NASDAQ:ATAX), for instance, pays a dividend of 7.44%, but is still worth more than what it was five years ago. Kinder Morgan Energy Partners (NYSE:KMP), which owns oil pipelines, sports a 6.72% dividend and is up 45% in value over the last five years.

There are going to be dogs in this pack, so tread carefully. Nursing homes, for instance, should never have become MLPs; they're really operating companies. But the public companies in the space were spurned by other healthcare companies, so now you have companies like Health Care REIT (HCN), which bought Sunrise Senior Living and sports both a 4.66% yield and a bit of capital appreciation.

Generally, the best MLPs are those that are the most passive, that are extracting and passing through a reliable stream of profits from the underlying assets. Just know that the idea here is that, as with oil wells, you're buying depletion -- these things go away. Despite all the caveats, MLPs today are what hedge funds were in the last decade. They're a favored way of making money, and the egos aren't yet holding them back. That will change after the next recession.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.