Investors who have chased the predictable income of master limited partnerships since the financial crisis should now be recognizing the flipside of a strategy that has benefitted from rising commodity prices and unprecedented monetary policy.
True believers in MLPs, which basically represent fee-collecting infrastructure for oil and gas, are clinging to history and, in some cases, fundamentals as reasons to hang in there.
In 2008, for instance, the Tortoise Midstream MLP Index dropped 38% only to gain 76% in 2009.
But that was back when commodity prices were screaming, the Federal Reserve was just getting started on its record-setting quantitative easing program and there was no such thing as an MLP mutual fund.
Through Sept. 30, MLPs, as measured by the Tortoise Midstream MLP Index, are down 42% from their August 2014 peak and are facing a double threat. Commodity prices are way down and the Fed is getting ready to raise interest rates.
Still, that's not enough reason to keep some investors away.
“It's been a bloodbath, for sure, but we think the noise is more about the price of commodities,” said Phil Blancato, chief executive officer at Ladenberg Thalmann Asset Management, which allocates between 3% and 5% of client portfolios to MLP investments.
Even as he commits to sticking with MLPs, Mr. Blancato acknowledges the risk that falling commodity prices could hurt some MLP income streams, which could in turn hit the dividend yields that are currently hovering about five percentage points over 10-year Treasury yields.
When the Fed finally raises rates, the move could be viewed as a sign of stronger economy that should be good for commodities and MLPs. But the other reality is that higher rates will both increase MLPs' borrowing costs and draw some income investors to bonds.
The entire MLP universe has about $600 billion, the bulk of which is in direct investment. Since the launch of the first MLP exchange-traded fund in 2009, there are 21 exchange-traded products totaling $16.5 billion offering exposure to MLPs. And since the launch of the first MLP mutual fund in 2010, there are 30 MLP mutual funds totaling $24.4 billion.
Thanks to the Tax Reform Act of 1986, which was designed to boost investment in mostly energy-related infrastructure projects, traditional MLPs provide certain tax advantages. As partnerships, they pay no state or federal income tax. Instead, distributions are taxed only at the marginal rate of their partners.
Once MLPs are wrapped in a mutual fund or an ETF, however, their distributions are taxed at the fund's corporate rate, and what is left is paid to shareholders as a distribution — which then is taxed as dividend income, thereby effectively nullifying the main reason for investing in an MLP in the first place.
Not only do mutual fund and ETF wrappers alter the tax and investment structures that are most appealing about MLPs, but they also invite a market of less-informed investors.
“You have had a remarkably uninformed investor enter the space en masse,” said David Bahnsen, chief investment officer of Bahnsen Group at Hightower Advisors.
The retail products “invited in a whole new type of investor of MLPs who was not aware of what they were buying,” he added. “That type of investor was never going to hold through a cycle like this.”
Through Oct. 6, the MLP mutual funds tracked by Morningstar Inc. have fallen by an average of 20.2%, with a 12-month decline of 26.2%.
By comparison, the S&P 500 Index is down 2.3% since the start of the year, and is up 2.9% over the past 12 months.
As Morningstar fund analyst Robert Goldsborough put it, the MLP space has been hit on three sides by the effects or potential effects of interest rates, currencies and commodity prices.
That's one way to explain away recent volatility in MLPs, and hope for another 2009-type rebound. But what is so much different this time around is the growing retail-investor influence, combined with the Fed's uncharted monetary policy.
“MLPs are supposed to be toll collectors that deal with volume, but we've never seen them in a down market for energy,” Mr. Goldsborough said. “Now we're seeing a down market for energy and it has not worked out very well, because despite how they were billed, they are not insulated from commodity-price volatility.”
Wrapping MLPs inside mutual funds and ETFs was a brilliant marketing move because even if the wrappers stripped away most of the advantages of owning an MLP directly, the funds gave retail investors some semblance of MLP exposure.
But if those funds don't start showing some positive performance, it is going to be difficult to keep those retail investors on board, which could move the entire category back to direct investing in MLPs where it probably belongs.