ETFs and Behavioral Finance

There are over three million stock indices in the world, more than 70 times as many as actual stocks. Before learning this startling fact in the FT the other day, I might have guessed wildly at 1% of this figure, thinking it way too high.

Although the growth in Exchange Traded Funds (ETFs) is not solely responsible for this index explosion, it’s certainly helped. The move away from active management has spurred the creation of indices into which passive funds can invest. At SL Advisors we recently made our own modest contribution to this thee million number by launching the investable American Energy Independence Index, in partnership with S&P Dow Jones Indices. Launching an index involves substantial work, but unlike an IPO there’s no 6% underwriting fee. Starting an index is cheaper than floating a stock.

The Shale Revolution has transformed America’s term of trade in energy, and created substantial opportunities for the infrastructure businesses who will help us towards Energy Independence. We identified a gap in the marketplace, since none of the available investment products offer exposure to this theme. A new index and associated ETF soon followed.

So it was that your blogger was at the Inside ETFs conference in Hollywood, FL last week. It’s an enormous event with (so we were told) a record 2,300 attendees. It’s a tangible measure of the growth in ETFs, marked by the S&P500 ETF (SPY) conveniently breaching the $300BN market capitalization threshold. The global ETF industry is over $4TN.

Non-investment luminaries such as Serena Williams and General Stan McChrystal added star power to the long list of finance experts giving presentations all day. We didn’t see any of them, because Inside ETFs is an enormous networking event. It’s become the can’t miss date of the year for everybody in the industry. Meetings with business partners and clients took up much of our planned schedule before arriving, and unexpected encounters filled the rest. You really can sit in the convention center lobby and enjoy serial, chance meetings with familiar faces.

The chatter is of success; of funds that generated strong early returns and have grown quickly. Of hot areas (Smart Beta), and underserved sector (European fixed income, believe it or not). It is Behavioral Finance in action. Positive results generate confidence, attracting more assets and more confidence. The winners keep winning. There’s no care for the unloved ETF. Efficient markets proponents hold that there ought to be no serial correlation in returns – in other words, no momentum. Prices reflect all available information, so short term moves are random. In the real world, rising prices attract more buyers, and falling prices draw more selling. This is why markets exhibit momentum, because like-minded people congregate to create a positive feedback loop.

Energy infrastructure endured the inverse of this for much of last year, as the growing divergence against almost all other sectors became self-reinforcing. Until late November, when the last frustrated tax-loss sellers exited stage left, signaling the beginning of a new trend.

In other news, U.S. crude output is set to reach an all-time record in 2018. You’d think it’d be hard to turn this into bad news, unless you’re a Russian oil producer/ But apparently there is a Dark Side of America’s Rise to Oil Superpower, according to Bloomberg BusinessWeek. Problems include the high quality of shale oil, which is lighter than the heavy crudes it’s displacing from countries such as Venezuela. This means it needs less refining. Although refineries may find certain expensively built processes no longer needed, ultimately producing refined products from it is cheaper. This is bad? Sounds like fake news; maybe the Russians planted the story.

The investable American Energy Independence Index (AEITR) finished the week +2.0%. Since the November 29th low in the sector, the AEITR has rebounded 15.0%.

 

The Folly of Leveraged ETFs

Recent weakness in crude oil has spilled over into Master Limited Partnerships (MLPs). Some connection between the two is understandable, because part of the bull case for MLPs lies in growing shale output increasing demand for energy infrastructure. Lower oil prices dampen the enthusiasm for the idea that Exploration and Production (E&P) companies will be competing for sometimes scarce pipeline resources. For our part, we think the short-cycle nature of shale offers a substantial advantage for producers (see What Matters More, Price or Volumes?). MLP investors often feel they must have a view on crude oil before investing; because U.S. volumes are likely to rise in almost any price scenario, we think it’s less important other than over the short term perhaps. Shifting your MLP exposure around in response to oil prices is not a good long term strategy. If you have a view on oil, invest in oil.

Profiting from owning crude oil is harder than you might think. Many ignore storage costs. While these aren’t directly reflected in spot prices, they are most assuredly part of the return from owning securities linked to the price of oil. The costly “rolldown”, by which the expiring near futures contract has to be regularly rolled into the next, higher priced one simply reflects the cost of storage. The approximately $1.20 per barrel price difference between May and August crude futures is largely due to the cost of storage for three months. Think of it as the time value of money applied to crude oil.

Exchange traded products linked to oil have a checkered past, which some think shows the need for a better solution aimed at those who would like to profit from their view of oil prices. ProShares, a purveyor of leveraged ETFs, has come up with a doozy.

Oil has been pretty volatile over the last few years. From its peak in 2014 its spot price dropped by 75% through February 2016, before doubling over the next year. If your version of excitement is a commodity price that gyrates wildly, you need look no further than oil futures.

But some find this tame. Downhill skiing may appear sedentary to those who insist a true mountain experience must be preceded by a helicopter ride to find real deep powder. But the kite skier needs a three-dimensional snow experience; if it’s not dangerous it’s not worth the trouble.

The kite skier is the type of buyer attracted to the ProShares UltraPro 3x Long  Crude Oil ETF, designed for those wanting to profit from rising crude oil (Ticker: OILU). And because excitement need not be limited to a rising market, they also have a bear market version (Ticker: OILD).

These two investments share a couple of traits with kite-skiing, in that they’re dangerous and not everyone involved will have a good time. OILU is designed to move each day by three times the percentage move in the Bloomberg WTI Crude Oil Sub-index. In order to maintain this 3X exposure to daily moves, OILU will need to rebalance its holdings every day. Without going into the messy details, this introduces the insidious nature of the use of leverage, in that rebalancing will always necessitate trading in the direction of the market. Following a rise in crude, they’ll need to buy more oil futures to bring their exposure back up to 3X. When it falls, they’ll need to sell oil to bring their exposure down to 3X.

As you can appreciate, if oil goes up and down but doesn’t make much overall progress, the buy high/sell low rhythm of re-hedging will relentlessly eat away at the holder’s value.

The last couple of years were interesting to say the least for oil traders. It’s possible to simulate how OILU and OILD would have performed for their holders over this period. The simulation omits fees and transactions costs, so the real results would have been a bit worse.

It might not surprise to learn that OILU lost money when oil went down. It is after all designed to make money if oil rises, so if your forecast is wrong OILU will not be your friend. Crude peaked in April 2014, and OILU would have lost 90% of its value by Christmas. Its chart looks rather like a kite skier suffering cardiac arrest. Although it’s hard to see, I can report that OILU did double in price when oil began to rally, albeit after falling 95%.

More surprising is that the bear market version, OILD, ultimately fared little better. Although crude oil is roughly half its value from three years ago, the OILD holder who made this correct forecast nonetheless saw his investment lose 70% of its value.

The point here is that 3X levered ETFs are not for those who develop an emotional attachment to their securities. The longer your holding period, the greater the certainty that you will lose money. Therefore, the optimal holding period is correspondingly as short as possible – or, if you’re not a kite skier, no holding period at all. Leverage means you care not just about the accuracy of your forecast but also about how quickly it happens. Predicting the near term path of prices as well as their ultimate resolution is how the over-confident are separated from their money. Leveraged ETFs are designed with the expectation that rebalancing will inexorably drive their value to zero.

The seductive and eye-catching part of the chart is of course the eightfold and eventually tenfold increase in the price of OILD. It was most definitely possible to make a lot of money from OILD. It required the possession of both oil price insight and exquisite timing, but for those blessed with both a healthy gain was to be had.

The problem is that, since few could have had such luck, over the three year simulation the typical holder lost money. Because ETFs don’t have a fixed share count some might quibble with this assertion; buying might have been substantial at low prices and inconsequential at high ones. It is unknowable of course, but in securities markets activity inevitably rises with prices. There would have most likely been many more buyers of these levered ETFs when they’d risen, further increasing the ranks of ultimate losers.

So you have a product that will be profitable for some but unprofitable for many and certainly for most. Should it even exist? How should we regard the supplier of something of whom the customers will for the most part suffer financially from their purchase? Is ProShares part of the efficient channeling of savings towards productive capital formation, the reason public capital markets exist? Or are they the casino owner, profiting from customers who on average will be richer by not entering?

And what’s wrong with that? Lottery ticket buyers, even the least financially sophisticated, pretty much understand that the odds are against them. In willful defiance of classical economic theory, lotteries nonetheless thrive even though the customers are selecting negative expected outcomes. They do this because the hope of winning, the dreaming of how that payoff would transform life, itself comes with positive utility. No ticket, no dream. Hope has value.

Is it therefore also true that users of ProShares products similarly comprehend the adverse odds they face and nonetheless derive utility from the hope of profit? Or is it more likely that they don’t perform the analysis above, and attribute any financial outcome to their expressed opinion rather than poor choice of product? In this case, the buyers of ProShares 3X products are less financially sophisticated than the lottery buyers they might regard with disdain. When waiting in 7-11 to buy milk while a customer ahead purchases a lottery ticket, the ProShares buyer should seek his financial advice. He might learn something. Lottery ticket buyers have more realistic expectations than ProShares buyers.

The ProShares prospectus details various dire outcomes that may result from a purchase. But of course nobody reads prospectuses, so they are legally compliant if not informative. However, shouldn’t there be a presumption that the typical holder of a ProShares product will profit if his underlying view is correct? What use is a supplier of financial products that largely destroy value? Demand certainly exists, as ProShares proudly notes on its website the $27BN in such ETFs they offer. But size of capital raised doesn’t prove intelligence by the investors, as the hedge fund industry routinely proves.

If some regard “ethical financier” as an oxymoron, it might be in part because of the values behind the offering of 3X leveraged ETFs. Just because something can be created doesn’t mean it should be.

A Few Thoughts on Long Term Energy Use

Every year Exxon Mobil publishes their outlook for global energy over the next 25 years. It’s an absorbing read for people who care about such things. Their projections may not all be right, but they have to think about such issues pretty carefully and make long term investment decision based in part on their views. In reading the latest edition: 2017 Outlook for Energy: A View to 2040, a few slides jumped out.

The U.S. Energy Information Agency (EIA) also just published their 2017 Annual Energy Outlook which includes projections out to 2040. Although these two reports are structured differently (Global versus U.S.; Exxon makes single case forecasts whereas EIA includes multiple scenarios) they are generally consistent. They agree on broad issues such as improving energy efficiency, more U.S. consumption of natural gas for electric power and industrial use, and gradually increasing crude oil production. The EIA forecasts the U.S. to be a net energy exporter within 5-10 years (depending on scenario), driven by sharply higher natural gas production displacing imports and leading to a net export position, and somewhat higher crude oil output reducing but not eliminating oil imports.

Although the world will drive more cars and many more miles thanks to demand in Asia, gasoline use for private automobiles is expected to peak within just a few years. Increasing use of electric and hybrid cars along with continued improvements in conventional engine fuel efficiency will more than offset more driving. China for example just announced plans to invest almost $400BN in renewable fuels by 2020. Although this is directed at reducing pollution from power generation, to the extent hybrid and electric cars gain market share in China they will use cleaner electricity. Based on today’s heavy reliance on coal for generating electricity, Chinese Tesla drivers have little to brag about. It’s also worth noting that the EIA in its Reference Case forecasts continued growth in U.S. exports of petroleum. This isn’t necessarily at odds with Exxon’s forecast of flat global gasoline use if U.S. refiners gain market share.

Germany has become a pioneer in the use of windpower, aided by many flat areas on which to build windmills as well as the very windy Baltic and North Seas. Germany sees itself as a leader in the use of renewable energy, a responsible global citizen limiting its contribution to global warming. And yet, few probably realize that the U.S. now generates electricity with less CO2 output than Germany. The improvement in the U.S. is due in large part to greater burning of natural gas instead of coal for electricity generation, a consequence of the Shale Revolution. Meanwhile, Germany’s green efforts have been harmed by its sharp reduction in nuclear power following the near meltdown of Japan’s Fukushima reactor in 2011. Renewables can only do so much, and as a result Germany’s use of coal has stayed higher than it might otherwise. Germans may not feel they need a lecture from Americans about saving the planet, but America can demonstrate better results.

The third slide highlights the highly undeveloped use of energy in homes across Africa and parts of Asia. Biomass (wood, in different forms) may be renewable but it’s not especially clean burning for those in its immediate vicinity. A complete assessment of its environmental impact is complex and depends on how it’s harvested, the climate, what type of wood and the available alternatives. We just found it surprising to see how much of the world still relies on a relatively primitive source of energy.

Finally, although demographics shift slowly, they’re still worth a look from time to time. China’s working age population is peaking around now. Since GDP growth comes from only three sources: (1) Labor force growth, (2) Productivity improvements and (3) Capital, Chinese GDP growth will need to come fully from the latter two now on. Developed economies are reckoned to be capable of 1-2% annual GDP growth before adding in the effect of labor force changes. Few are forecasting that China’s GDP growth will sink to this level, but it’s an interesting thought that ALL their growth will have to come from doing things better than before.

Meanwhile, Africa is forecast to add twice the population of North America in about a generation. Providing food, employment, housing and infrastructure for so many people is a challenge no region of the world has faced before.

 

The Bond Market Loses Its Friends

In 2013, my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors presented a populist framework for evaluating interest rates. The prospects for the bond market can only be evaluated by considering the U.S. fiscal situation, which is steadily deteriorating along with that of many states. I was dismayed to read the other day of an analysis that places New Jersey (where I live) dead last behind even Illinois in its funding of public sector pensions. We have, at almost every level of government and household, too much debt.

The solution has, since the 2008 Financial Crisis been low rates. If you owe a lot of money low rates are better than high ones. Financial repression in the form of returns that fail to beat inflation after taxes is a stealth means of transferring wealth from savers (lenders) to borrowers. Count the central banks of China and Japan with their >$1TN in U.S. treasury holdings among those on the wrong side of this trade, along with many other foreign governments and sovereign wealth funds.

Some have argued that low rates only help the wealthy (through driving up asset prices); they impede lending (because lending rates aren’t high enough to induce banks to take risk); they force savers to save more (thereby consuming less) than they otherwise would, because returns are so low; and they communicate central bank concern about future economic prospects. Low mortgage rates help homeowners and drive up home values which helps McMansion owners but not first-time buyers. Low rates may be good for the wealthy, and by lessening the burden of the government’s debt they may indirectly help everyone. But to someone with little or no savings, the tangible benefits are not obvious even if they are real (through higher employment, for example).

Nonetheless, we are likely at the early stages of watching this benign process swing into reverse. The conventional result of lower taxes combined with higher spending should be a wider deficit, rising inflation and therefore higher interest rates. The bond market is already beginning to price this in through higher yields, well before any discussions of next year’s budget (or even the appointment of a White House Budget Director).

Part of the problem is that bonds don’t offer much value to begin with. They’ve represented an over-priced asset class for years, and it’ll take more than a 0.50% jump in yields to fix that. From 1928 until 2008 when the Federal Reserve’s Quantitative Easing program began distorting yields, the average annual return over inflation (that is, the real return) on ten year treasuries was 1.7%. This is calculated by comparing the average yield each year with the inflation rate that prevailed over the subsequent decade-long holding period of that security. So investing in a ten year treasury note today at 2% would, if the Fed hits its inflation target of 2% over the next ten years, deliver a 0% real return (worse after taxes).

Given the Federal Reserve’s 2% inflation target, even a 4% ten year treasury (roughly double its current yield) would appear to represent a no better than neutral valuation. The deficit was already set to begin rising again before even considering any Republican-enacted tax cuts and other stimulus (such as infrastructure spending). In fact, borrowing at today’s low rates to invest in projects that will improve productivity makes sense in many cases. But under such circumstances, with the possibility of inflation above 2%, perhaps a yield of 5% or even 6% is the threshold at which ten year treasuries (and by extension other long term U.S. corporate bonds at an appropriate spread higher) could justify an investment.

Holding out for such a yield is fanciful. Millions of investors demand far less, which is why we don’t bother with the bond market. Our valuation requirements render us wholly uncompetitive buyers.

Low rates may be the best policy for America, but it looks as if we’re about to try boosting growth through greater fiscal stimulus. The Federal Reserve will seek to normalize short term rates, perhaps faster than their current practice of annual 0.25% hikes. The twin friends of gridlock-induced fiscal discipline (sort of) and low rates are moving on, leaving fixed income investors to fend for themselves. Bonds are a very long way from representing an attractive investment.

 

Initial Reaction to the Election

As we all digest the election results, and amid much near term market uncertainty, a few thoughts:

Good businesses in America will for the most part still be good businesses. The shift in political direction will likely include less regulation and in some cases deregulation. Domestic energy infrastructure with its ability to exploit America’s shale resources and limit our dependence on crude oil exports is unlikely to be one of the economy’s losers. While the turmoil in equity markets raises concern of an economic slowdown, the operating performance of midstream Master Limited Partnerships (MLPs) was only modestly affected by last year’s collapse in crude oil prices. Energy consumption in the U.S. is remarkably stable from year to year, and fee-based contracts that limit commodity price risk are widely employed. We think in times of uncertainty, investments in domestic energy infrastructure are one of the more robust choices you can make.

With promises of tax cuts, infrastructure spending and a vow to replace Janet Yellen because of the Fed’s low rate policy, there’s little reason to be constructive on bonds.

Why Market Timing Can Be Seductive

We generally don’t keep CNBC on at our office. Its relentless focus on the short term, punctuated with incessant commercials, make it a needless distraction. That’s why they hire attractive presenters. However, when passing the office next door I did notice a headline saying we’d gone 33 consecutive days without a 1% move in the stock market.

I presume it’s a record of sorts – there has certainly been a dearth of market-moving news lately. It reminded me of that frequent advice to stay invested because a relatively small number of months provide a surprising amount of the total return. And it’s true; using S&P data back to 1900, totaling 1,400 months, had you by some terrible misfortune been out of the market for the ten best months your $1 invested in January 1900 would have only grown to $70, rather than $363 if you’d stayed in the whole time. Mind you, even if you “only” had the $70 at the end of 1,400 months, you’d still have achieved success by longevity and probably wouldn’t care about the money.

Obviously when investors temporarily exit the market, they’re trying to avoid the bad months not miss the good ones. And here’s the thing that’s perhaps not intuitive; if our investor, in missing the ten best months also managed to skip the ten worst ones, he’d be better off than if he did nothing with a terminal wealth of $493.

This places the folly of market timing in a somewhat different light. Under the circumstances, perhaps trying to avoid the bad months is a worthwhile objective since they are disproportionately more damaging. Surely, you’re just as likely to miss a bad month as a good one, or indeed equally likely to miss the worst month as the best?

Sadly, like most investment models that can be thrown together in thirty minutes on a spreadsheet, it’s not that simple. Our market-timing investor is unlikely to miss the best or the worst months, but will probably miss the typical months. Because more months are up than down, the typical monthly return is positive. Since January 1900 we’ve had 828 up months, 59% of the total. The likelihood is that by chance he’ll miss more up months than down ones, and his overall returns will be worse.

The Shrinking Pool of Cheap Assets

Stocks have in recent years been the destination of choice for bond refugees. The guiding strategy behind monetary policy since 2008 has been to drive investors into riskier assets so as to boost economic growth. Amid mounting evidence that this objective was being achieved, the Federal Reserve has contemplated the timing around ending this strategy by normalizing rates. In fact, the Federal Reserve has provided so many false warnings of an impending tightening of monetary policy that it’s barely worth paying attention. I have kept track of their evolving rate forecasts ever since they began providing greater precision back in January 2012. The chart of “blue dots” represents individual FOMC members’ expectations for the Fed Funds rate. Four and a half years ago they kicked off this greater openness with a forecast of a single tightening that year and a 0.75% rate by 2014. It’s fair to say that in early 2012 none of them expected the August 2016 funds rate to be where it is at 0.25%. Ever since they started with the blue dots, they’ve strained to adapt their updated forecasts to their persistent inaction.  It has been an amusing if not especially informative spectacle. You’d think it would be easier to get it right than the record suggests — they are, after all, merely trying to forecast their own actions. However, tactics regularly overwhelm strategy, as a moment of weakness in any sector of the economy is extrapolated into the possibility of a disappointing GDP number. If you look hard enough, there’s always softness somewhere. FOMC members possess many skills, but good forecasters they are not.

Not everyone has been surprised by the lethargic return to “normal” interest rates. Since it is the political season (i.e. shameless self-promotion is all around us), back in 2013 your blogger noted high levels of public debt and concluded that, “As a society we want low rates, and the Federal Reserve is pursuing a set of policies that are clearly in the public interest.” See Bonds Are Not Forever; The Crisis Facing Fixed Income Investors (Wiley, 2013).

Consequently, interest rates have remained lower for far longer than most investors expected. Every fixed rate mortgage has turned out to be more expensive than going with an adjustable one. Every non-defaulting corporate bond issued was, in hindsight, more costly than relying on floating rate debt. Eventually a borrower somewhere will lock in an all-time low in rates, but it hasn’t happened yet.

It’s not hard to find examples of strong performance in bonds, but even by recent standards I found the chart below from the Financial Times striking. The UK may have voted itself a recession via Brexit, but among the winners are holders of long-dated Sterling denominated corporate bonds whose prices in some cases have reached two times their par value at maturity.

Because of continued central bank monetary accommodation, the indices touching new highs are many and varied. Stocks, bonds, utilities and REITs are all at or very close to all- time best levels. As a result their yields are all commensurately paltry, as one might expect. By comparison, energy infrastructure, as represented by the Alerian MLP Index, offers both a substantially higher yield and a meaningful discount to its former high. With so many asset classes trading at hitherto unseen levels, it’s increasingly difficult to identify pockets of value. Momentum investors of course have plenty of choices, since so many sectors have strong upward momentum. MLPs have been no recent laggard on this score either, having leapt 60% from their low this past February. But it seems to us that if you like your investments to offer some kind of value cushion for when the momentum inevitably turns, MLPs should hold your attention. The yield spread between MLPs and REITs remains close to the widest levels it reached during the 2008 financial crisis. Switching from REITs or Utilities into MLPs looks like a portfolio upgrade.

More Thoughts on Brexit; AMLP Reaches a Milestone

The Brexit vote is now two weeks behind us and I still watch developments with jaw agape. Rarely in history has the consequence of a popular vote led so directly to a recession. The IMF has forecast that the UK economy will shrink by 1.5% through 2019 if they agree to a Norway-style EU access (i.e. similar EU budget obligations, lack of immigration controls and submission to EU regulations but with no ability to influence them, not exactly what Brexiteers voted for). Or, if EU access conforms to the World Trade Organization (WTO) tariff framework, the UK economy will shrink by 4.5%. Leading Brexit campaigners such as Boris Johnson and Nigel Farage have exited stage left now that their goals have been achieved. Brexit voters gamely advise that everything will be OK, while decision makers prepare for a recession. Fewer UK jobs will likely reduce immigration anyway, although this is hardly the best means of achieving that goal. And yet, in theory the entire non-UK EU population of almost 450 million people could have relocated to the UK, at which point the country would have resembled a Piccadilly line tube train at 5pm. Free movement of people, a core, inviolable principle of the EU, is absurd.

Nonetheless, Brexit was not a carefully considered response but a visceral reaction with far-reaching and poorly considered consequences. Churchill  once said, “The best argument against democracy is a five-minute conversation with the average voter.” Brexit leaders have led their followers to the cliff and then retired to the pub for a drink while they watch the leaderless deal with the aftermath.

One result is that bond yields globally have fallen to hitherto unimaginable levels. The Barclays Aggregate Index is +6% YTD, beating the S&P500. Regular readers will be familiar with our past illustration of the paltry returns available on bonds whereby we compare a barbell of stocks and cash with the ten year return on bonds. In our April newsletter we wrote about The MLP Risk Premium. With reasonable assumptions about MLP distribution growth rates and prevailing valuations in ten years, you could swap out your bond portfolio for as little as 10% in MLPs with the rest in cash while still achieving a bond-like return. MLP yields have fallen since we wrote that in April, but so have bond yields so the broad set of choices still favors almost anything over bonds but certainly still MLPs.

Federal Open Market Committee (FOMC) minutes released last week confirmed what we’ve long noted, that Janet Yellen will never miss an opportunity to avoid raising rates. Ignore their words and try considering this Fed’s actions as if they’d announced the solution to excessive debt was to keep rates low for a long time. The rhetoric doesn’t reflect such a strategy but their actions most assuredly do. Waiting for rates high enough to justify an investment requires substantial patience, during which time investors are steadily pursuing equity-type risk with its better return prospects.

Tallgrass Energy GP (TEGP) raised its quarterly distribution by 16.7% quarter-on-quarter and 84.2% year-on-year from its pro-forma 2Q15 level. Not every MLP or GP is raising its distribution by any means, but less than six months ago such would have been unthinkable. Meanwhile, the Alerian MLP ETF (AMLP) reached a milestone of sorts, in that the recent recovery in MLPs has finally moved AMLP to where it once again has unrealized gains on its portfolio. As we noted in March (see Are You in the Wrong MLP Fund?) this is the point from which AMLP investors will now earn only 65% of any subsequent upside since the U.S. Treasury will take 35% through corporate tax. Indeed, the tax drag has already had an effect, since AMLP’s YTD performance through June 30 is +10.7% versus the Alerian Infrastructure Index +13.1%. Those AMLP investors who are bullish on the sector (which presumably includes all of them) will, if right, contribute modestly to Federal finances at the expense of their own investment results and reputation for careful analysis. AMLP is the refuge of those who stop at Pg 1 of a prospectus rather than examining Pg 23, Federal Income Taxation of the Fund. This is part of the reason why a more thoughtfully designed, non-taxable, RIC-compliant MLP fund (which we run) has done very well.

We are invested in TEGP.

Hearts Outvote Heads in Brexit

Brexit Image It’s been 34 years since I left the UK and moved to the U.S., and 25 years since I became a U.S. citizen. I long ago lost the right to vote in UK elections, having by now spent two thirds of my life in the New World. But I shall never lose my pride at growing up English nor my intense interest in what’s happening there.
So I have followed the Brexit vote avidly. It has been described as a struggle between the head, which rationally questions how the UK’s economic prospects can be better with the uncertainty of leaving, and the heart, which laments the loss of sovereignty which EU membership demands. Had I voted, my head would have won and I would have checked the “Remain” box, but I have friends on both sides of this highly divisive issue and I can appreciate the frustrations of the majority. Meanwhile, the EU faces another existential crisis.

U.S. citizens are often aghast to learn of the rules agreed to by successive UK governments in order to be an EU member.  The British tabloid press routinely shouts about un-elected bureaucrats in Brussels imposing ridiculous standards of conformity, apparently to promote a more competitive EU-wide market, Many are untrue and some apocryphal, but bananas and cucumbers (to cite just one example) are subject to EU standards on size and curvature. One struggles to comprehend the mindset behind these or the motivation of those who toil to make such rules. I recently heard that EU horseshoes have certain size requirements, which causes at least one UK blacksmith to painstakingly heat and reshape the ones he buys before they’ll fit local horses. Although I couldn’t independently confirm this story, there have been enough similar instances to cause millions of Britons to roll their eyes.

But the major issue was immigration, and an enlarging EU burdened with permanently slow growth because of its catastrophic embrace of the Euro has seen increasing numbers of its citizens migrate north-west to the UK’s more vibrant economy and job market. EU membership requires free movement of EU citizens within EU borders, and an island nation that has repelled European invaders for many centuries was never going to sit comfortably with this. When I was growing up, a vacation in Italy was described as “going to Europe” or to “the Continent”. “Fog in English Channel — Continent Cut Off”  is thought to be a newspaper headline from my grandparents’ time. Whether it actually existed or not, the sentiments it represents did, and in some cases perhaps remain today.

If George Soros and other speculators had not demonstrated so spectacularly in 1992 that the British Pound could not stay linked to the Deutsche Mark, the UK might have subsequently joined the Euro, and by now be suffering similarly slow growth with the rest of the Eurozone. It would at least have deterred some immigration. But Britain has always been more ambivalent about the EU than its founding members. The welcoming of over one million refugees into Germany last year, while a huge and selfless act by Germans, rendered UK PM David Cameron’s promises to limit immigration both more vital and less credible.

When a country eschews tangible economic results such as GDP growth and job creation in favor of intangibles like a feeling of greater sovereignty, investors must acknowledge that the pursuit of corporate profits is not everyone’s priority. While it’s foolish to infer anything about the U.S. election, free trade isn’t as important to as many people as establishment politicians might hope. Populism is a force in other  countries including the U.S. The benefits of open markets are broad but not uniformly distributed, and the less economically fortunate are finding their voice.

The vote split sharply along regional lines, with London, Scotland and Northern Ireland voting to Remain while most of the rest of England chose Leave. Now a second Scottish independence referendum is likely and it may see the union of 1707 dissolved, while Northern Ireland may be reunited with the Irish Republic. A diminished Britain reduced to England and Wales may seek to deepen its economic ties with the U.S.; London to New York is 3,500 miles, 1,000 miles more than Los Angeles to Hawaii. Or the UK may have second thoughts about Brexit, since the economic pain is likely to occur far sooner than freedom from EU rules. A second EU member could also leave — the Netherlands may hold their own referendum. There are many possibilities and few certainties. Nobody can really be sure how events will unfold.

There was also a generational divide, with younger voters less bothered by immigration and enamored of their EU-wide mobility while older voters reflected nostalgia for the Greater, more ethnically Anglo-Saxon, Britain  of old. Because of the propensity of seniors to choose Brexit, a meaningful portion of the 3.8% margin of victory will have passed on before the UK finally negotiates its exit. Consider this quote from one young voter: “Freedom of movement was taken away by our parents, uncles, and grandparents in a parting blow to a generation that was already drowning in the debts of our predecessors.” U.S. baby-boomers are also leaving an unwelcome legacy of debts to cover their un-financed retirement healthcare (Medicare). Different generations are steadily finding theirs interests no longer aligned.

Brexit’s economic impact will affect the UK economy substantially with some forecasting an immediate recession because of the uncertainty. Any long term investment decision confronts acutely difficult assumptions. But if it’s bad for the UK it must be worse for the Eurozone. At least the UK knows where it’s going if not exactly how it’ll get there. Many other EU countries know neither, which is why Eurozone stock markets fell substantially more than the UK’s FTSE. Brexit is far from being just a UK problem. The Euro really didn’t need this.

Nonetheless, life will go on. Consumers will buy what they need and energy will be produced and used. Low volatility stocks will remain that way, relative to the S&P 500 at any rate, and U.S. energy infrastructure is, thankfully, over here rather than over there. Not immune to the turmoil voters have unleashed, but only tangentially impacted.

UK voters have finally tired of an EU that delivers edicts and fiscal austerity. While I wouldn’t have voted to Leave, I am deeply proud of this small but highly consequential nation that has the self confidence to abandon the certainty of a dysfunctional club so as to take back control of its future, uncertain though it may be.

Equity Underwriting for Dummies; Kinder's Blunder

If a banker approaches the CEO of a Master Limited Partnership (MLP) with an offer to help, the CEO should run (not walk) in the other direction. The latest victim is the management of Columbia Pipeline Group Inc (CPGX). A month ago management had indicated that they’d be tapping the markets for equity via their MLP, Columbia Pipeline Partners (CPPL). This is how it’s meant to work, with CPGX as the General Partner (GP) directing the MLP it controls to raise capital and invest it, sending half the free cashflow up to CPGX via the Incentive Distribution Rights (IDRs). They currently have $8BN in projects, notwithstanding the market’s current skepticism about MLP growth prospects. To reuse the hedge fund analogy, CPGX is the hedge fund manager (i.e. earning a share of the profits and providing management) and CPPL is the hedge fund (i.e. doing as directed by the GP).

But a month later, no doubt advised by its self-serving equity underwriters Goldman Sachs and Credit Suisse, CPGX instead issued equity, thereby raising capital at the GP level rather than the MLP level. “Hedge fund manager dilutes itself by issuing equity” is not a headline as commonly viewed as “Investors pile into hedge fund”. In this case, CPGX acted as the former when they ought to know better.

Goldman and Credit Suisse did what they do well, which is to ensure that CPGX stock traded down until the moment of pricing, ensuring a profit for the underwriters and favored clients at the expense of existing CPGX investors. The offering was priced at $17.50 on December 1, an 8% discount to the prior day’s close and a level at which it had never previously traded. Due to strong demand the offering was upsized from 51M shares to 71.5 and the stock quickly traded up while the underwriters exercised their option to buy an additional 10.725 million shares (upsized from 7.65 million shares) on top of the 71 million originally sold. Clearly, the market was not surprised; the circumstantial evidence points strongly to the underwriters alerting clients to the offering in the preceding days and thereby softening the market. This is because only the underwriters had both the advance knowledge of the offering and the incentive to see the stock trade off in the days prior to pricing.  Perhaps the equity capital markets staff use hand signals to alert their colleagues on the other side of the Chinese wall about what’s coming, so as to avoid leaving any evidence of their communication. In any event, the result was a success for all involved, except regrettably for CPGX investors whose shares were valued as high as $22 just a month earlier. Make that another win for Wall Street bankers. My book Wall Street Potholes will soon need a Volume 2. You can never be too cynical.

CPGX Dec 4 2015 Revised

 

I reviewed several corporate finance blunders a few weeks ago in Investment Bankers Are Not Helping MLPs. Kinder Morgan (KMI) was part of that with their poorly handled offer of mandatory convertible securities. But on reflection, they may have committed the biggest blunder of all last year with their restructuring in August 2014. It looked clever at the time, and to our subsequent regret we liked it (see Valuing Kinder Morgan in Its new Structure). By acquiring their MLPs, Kinder Morgan Partners (KMP) and El Paso (EP), they were able to revalue their assets to current market prices and thereby create a higher tax-deductible depreciation charge that fueled a faster growth rate in their dividend. It was pretty slick.

But in hindsight, the reasons for the restructuring were a warning. At their size, they were unable to finance enough accretive projects to continue growing their dividend at its previous rate. The hedge fund analogy is useful here, because almost every hedge fund eventually gets too big. KMI, the GP of two MLPs and in effect the hedge fund manager, should have accepted that slower growth was inevitable and been satisfied with 1) a recurring 6.8% distribution yield growing modestly at KMP, effectively its hedge fund, or 2) consolidating and financing growth from retained earnings like all the other large C-corps. Instead, they adopted a structure yielding 5% with 10% projected growth fueled by the higher depreciation charge but reliant on equity markets to provide capital to finance part of their growth. Fifteen months and a more than 50% drop later, they now have a 12% yielding security with 6-10% 2016 growth and questions swirl about their ability to finance accretive projects given that their cost of equity has doubled. Moreover, it’s no longer an MLP, and the pool of potential investors, while large, looks beyond distributable cashflow and distribution yield and to other metrics such as Enterprise Value/EBITDA, against which it didn’t look quite so cheap at the time.

It’s no doubt a better investment today than it was in August 2014, and it remains a modest holding of ours although substantially less than in the past as we’ve switched into more attractive names. But the MLP-GP structure, with its close comparison to the hedge fund-hedge fund manager, is how Rich Kinder became a billionaire. Incentive distribution rights, the mechanism by which KMI earned roughly half the free cashflow from KMP and (more recently) EP, are similar to a hedge fund manager’s 20% incentive fee. Rich Kinder was smart enough to figure that out, but not smart enough to recognize when it’s time to stop accessing the secondary market for financing.  The largest MLP, Enterprise Products (EPD), funds its growth from internally generated cashflow rather than issuing equity  and has 1.3x coverage on its distribution. Perhaps that’s why EPD unitholders have fared better.

Size is the enemy of performance in hedge funds and, at times, in MLPs. Shame on Rich Kinder for not realizing it and instead letting the investment bankers talk him into the value destroying structure. He bet faster growth would drive down the yield on KMI, making it an acquisition currency of less leveraged businesses in a downturn, which would in turn reduce KMI’s leverage. The strategy has backfired. KMI no longer gets credit for the dividend, which leads to questions about its sustainability. While it’s covered by cashflow and they don’t need to issue new equity until 2H16 since doing the mandatory convertible, if KMI still yields >10% in late 2016 it’ll make more sense for them to cut the dividend and thereby reduce or eliminate their need for additional equity. KMI has made the mistake of many hedge fund managers and investors, thinking they can grow indefinitely. Although some commentators are worried about pressure on pipeline tariffs from stressed E&P companies, there’s a stronger case for tariff increases since the cost of equity for pipeline owners (i.e. MLPs) has risen.

Hedge fund managers don’t buy their hedge funds, and MLP GPs shouldn’t buy their MLPs. Management at Targa Resources (TRGP) should take note (see Targa Resources Needs an Activist).

We are invested in CPGX, EPD, KMI and TRGP.