The Alerian MLP ETF (AMLP), with its tax-burdened structure (see AMLP’s Tax Bondage), is by design unable to come close to the return on its benchmark, the Alerian MLP Infrastructure Index (AMZI). Because AMLP doesn’t qualify for treatment as a Regulated Investment Company (RIC), it’s subject to corporate income taxes just like any other corporation. The fund’s tax liability has acted as a substantial drag on returns; since inception in 2010, it has returned just 1.99% (through June 30th), less than half its benchmark of 4.39%.

When AMLP’s portfolio rises, its NAV lags by the amount of the additional tax liability. When its holdings fall, AMLP reduces its taxes owed which cushions the blow somewhat. In fact, the tax drag acts to dampen its volatility. Tax-impaired returns ought not to be that attractive, although occasionally an investor notes that he likes the resulting lower volatility. While MLPs have been choppy in recent years, embracing this type of tax-encumbered, reduced price movement seems wrongheaded; after all, AMLP holders presumably expect a positive return, and the tax structure lowers it.

AMLP is simply the biggest of around $50BN in flawed funds. The chart below is from an Oppenheimer prospectus which helpfully explains how taxes hurt returns on their funds.

.avia-image-container.av-46wqn4-5ff82a133333ab5af23ae337652e062c img.avia_image{ box-shadow:none; } .avia-image-container.av-46wqn4-5ff82a133333ab5af23ae337652e062c .av-image-caption-overlay-center{ color:#ffffff; }

In an additional wrinkle to the pay-off profile, taxes only accrue when AMLP has unrealized gains. In such cases it holds a Deferred Tax Liability (DTL). When it has unrealized losses, as currently, it doesn’t accrue a tax loss carryforward, or Deferred Tax Asset (DTA). At such times the tax-induced low volatility disappears, and AMLP moves up and down with the market.

.avia-image-container.av-26c7ps-b393e982f1fd97dca9b32d1465a42963 img.avia_image{ box-shadow:none; } .avia-image-container.av-26c7ps-b393e982f1fd97dca9b32d1465a42963 .av-image-caption-overlay-center{ color:#ffffff; }

We are approaching an inflection point. AMLP’s unrealized losses are shrinking as the sector grinds higher. Its current DTA (which is offset with a valuation allowance, thus negating it) will flip to a DTL with the next 4-5% rise in its portfolio. At that point, further gains will trigger taxes owed. Its modestly lower volatility will return. With an approximate tax rate of 23%, AMLP will provide its holders with only 77% of the upside or all of the downside.

Like the approach of a surfer’s perfect wave, this situation offers the AMLP short-seller a rare, asymmetric opportunity. Just as an AMLP holder is accepting diminished upside for full downside risk, the AMLP short will enjoy the complete benefit on the downside with constrained losses on the upside. Combining a short AMLP with a diversified long position in energy infrastructure names or a properly structured, RIC-compliant, non-tax-burdened fund creates an interesting trading opportunity.

Such a long/short portfolio should be profitable in a rising market and roughly breakeven in a down market. There are financing costs, but AMLP has $10BN outstanding and so is not that hard to borrow.

Because AMLP is 100% invested in MLPs, a diversified long portfolio that includes energy infrastructure corporations further allows the investor to bet on a continued shrinking of MLPs as a subsector of energy infrastructure. As the biggest MLPs convert to corporations where they can access a far bigger set of buyers, this leaves fewer names with a lower median market cap (see Are MLPs Going Away?). MLP fund investors face the additional risk that one of the larger funds elects to drop the tax burden by selling 75% of its MLPs, becoming RIC-compliant. This could depress MLPs and hurt valuations of all MLP-dedicated funds.

This kind of asymmetry has value. Option premiums reflect the substantial upside/downside difference for the holder. Long-dated bonds (most dramatically, zero-coupon bonds) also offer a modest amount of asymmetry due to convexity, which causes investors to drive their yields somewhat lower than they’d otherwise be. In theory, AMLP should trade at a discount to NAV because of its tax-driven asymmetry, reducing the benefits of shorting and providing some additional return to holders to compensate for its flawed structure. Because the AMLP short is receiving the benefit of the tax drag, it’s one of the few ways you can really get Uncle Sam to work for you.

The benefits of shorting AMLP highlight the diminished return prospects of the holders. There are several other similarly tax-impaired funds, including mutual fund products from Oppenheimer SteelPath, Cushing Mainstay and Goldman Sachs, and a couple of small ETFs. While none of these are short candidates, they all suffer from the same structural flaws as AMLP. Their holders are unlikely to enjoy returns close to the indices, even while they incur unimpeded downside risk.

MLP-dedicated funds are unique in owing taxes at the fund level. Fund investors seeking energy infrastructure exposure should select a RIC-compliant, non-tax paying fund with less than 25% in MLPs.

We are short AMLP.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

2013 and 2014 were great investing years. The S&P500 was +32% in 2013 and followed up with +14% the following year. MLPs also delivered strong performance. As long-time investors know, the Alerian MLP Index peaked in 2014 and even now remains 35% lower, while the S&P500 has continued to scale new heights.

Investors in MLP-dedicated mutual funds and ETFs yearn for a repeat, and probably feel entitled to one. Investors in such products are generally not looking for 5-10% either. Given what the sector has endured, the returns of 4-5 years ago would not be amiss. Last week the sector finally turned positive YTD — such optimistic thoughts do not seem out of place.

Those hoping for such may want to consider their choice of vehicle. MLP-dedicated funds are taxed as corporations, and so they pay taxes as well as other operating expenses before delivering their taxable returns to investors. These funds labored under some of the highest expense ratios in the industry during those banner years. Their tax expense is fully disclosed, but still in our experience poorly understood. Sitting with a financial advisor and educating him on a previously unfathomable expense burden still routinely elicits embarrassment and shock.

The chart below shows the 2013-14 expense ratios of some of the biggest MLP-dedicated funds. Although corporate tax rates are now lower, the structural inefficiency persists. If MLPs do manage a couple of years of outsized performance, investors are likely to be surprised at the expenses that are deducted from their returns. Getting the sector right but picking the wrong investment is an avoidable tragedy (see AMLP’s Tax Bondage).

.avia-image-container.av-6t6dy-5a8e029213ca85f9a9e5823b8cc80d4f img.avia_image{ box-shadow:none; } .avia-image-container.av-6t6dy-5a8e029213ca85f9a9e5823b8cc80d4f .av-image-caption-overlay-center{ color:#ffffff; }

In 2013, the funds in the chart had an average expense ratio of 9.4%. With average returns of 18.2%, around a third of the gross return was eaten up in expenses, most of which was corporate taxes. Six years ago in The Hedge Fund Mirage, I showed how the profits had split very unevenly between fees to managers versus returns to clients. It surprised many, although not the fund managers who well understood and enjoyed the imbalance. The 2013-14 result in MLP funds was similar, although the offending expenses in this case are corporate taxes rather than manager fees. Nonetheless, considering that investors still have to meet their own tax liability on the net investment results, these look like products that the Federal government might have designed.

Promoters will explain that all MLP funds are taxable, which is true. When investing in energy infrastructure meant MLPs, that was perhaps a defensible argument. But many of today’s biggest energy infrastructure businesses have abandoned the MLP structure. They’ve found the investor base to be fickle, limited to older wealthy Americans who prefer income and are unwilling to finance the growth opportunities opened up by the Shale Revolution. These long-time buyers have been badly abused, with multiple distribution cuts and adverse tax outcomes when their MLP simplifies by combining with its corporate parent. It should be no surprise that MLP yield spreads versus ten year treasuries remain historically wide.

In May, Williams Companies (WMB) rolled up their MLP into their corporate parent (see Transco Dumps Its MLP). Enbridge (ENB) also simplified their structure on the same day. Both cited regulatory uncertainty caused by the FERC ruling (see FERC Ruling Pushes Pipelines Out of MLPs). But the difficulty of raising equity capital for an MLP is an issue for many.

As a result, tax-burdened MLP-dedicated funds are now confronting a shrinking set of opportunities. They are becoming an anachronism, as the energy infrastructure industry steadily leaves the MLP buyer behind in favor of a far bigger set of investors.

Moreover, the shrinking MLP universe is going to create further challenges for such funds (see The Alerian Problem). At the annual MLP conference in Orlando, many participants commented that an MLP-only index was now inadequate, no longer reflective of the energy infrastructure sector (see The Uncertain Future of MLP-Dedicated Funds). MLPs are less than half of North American midstream energy infrastructure, a point recently tweeted by Hinds Howard of CBRE Clarion Securities (@MLPGuy).

Managers of MLP-dedicated funds are telling their clients not to worry — as they would given their MLP-centric business model. But a shrinking index is rare in Finance, and offers the fund manager few good options: (1) Do nothing, and hope your clients tolerate a more concentrated portfolio with smaller names; (2) Start holding corporations as well as MLPs. This would require an ingenious explanation, because you’d now have taxable corporations sitting in a tax-paying fund delivering taxable returns to investors, a solution with poor optics; (3) Switch to a broader index and become RIC-compliant. This is the nuclear option, since it requires an MLP-dedicated fund to shed 75% of its holdings in order to come under the 25% MLP limit necessary to be RIC-compliant. If the $10BN Alerian MLP ETF (AMLP) sold $7.5BN of MLPs, they’d find that by the time they were done with that, for MLP prices, down is a long way. It’s unlikely they could seriously contemplate such a choice — their investors should hope they never do.

AMLP is the biggest of these flawed funds. In 2013-14 its expense ratio was 8.6% and 8.8% respectively. Today, AMLP has modest unrealized losses; a continued recovery in the sector will soon turn these into gains, resulting in AMLP once again incurring a Deferred Tax Liability along the lines of 2013-14. Since it’s close to the inflection point at which it becomes a taxpayer, shorting AMLP exploits the attractive asymmetry of a tax drag impeding its rise, while it will still reflect the full force of a market drop. It’ll rise at approximately only 77% of the index, and fall 100% of it. AMLP as a short can be combined with a long position in a portfolio of energy infrastructure corporations, or even with a correctly structured, RIC-compliant fund with no tax drag. Such a paired trade combines long positions focused on energy infrastructure corporations, which have very strong fundamentals, with a short position focused on the MLP structure than is increasingly being abandoned.

We are long ENB and WMB. We are short AMLP.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last November SS&C Alps Advisors, the people who manage the Alerian MLP ETF (AMLP), admitted that they’d screwed up calculating the taxes owed by their fund. Mutual funds and ETFs don’t pay taxes as long as they comply with the rules of the 1940 Investment Company Act for an exemption. AMLP does not comply, because it invests in Master Limited Partnerships (MLPs). Owning more than 25% renders a fund non-RIC compliant and therefore liable for taxes like any other American company. AMLP is 100% MLPs.

We have written tirelessly on the topic (see MLP Funds Made for Uncle Sam). Last December we noted AMLP’s reduced NAV (see AMLP Trips Up On Tax Complexity) which fell 3.9% at their November fiscal year-end. Because of its flawed structure concentrated on MLPs and thereby liable for corporate taxes, AMLP has a five year annual return of 4.97%. The Alerian MLP Index, which it seeks to track, has returned 7.42%. The 2.45% difference is partly AMLP’s 0.85% annual management fee, but mostly the burden of taxes. By contrast, the investible American Energy Independence Index (AEITR) has a five year return of 11.06%.

Nobody would create AMLP today. MLPs are around a third of the sector, and their numbers continue to decline. It is a relic of a decade ago when the MLP structure dominated. That is no longer the case.

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) a couple of weeks ago caused smaller MLPs to briefly catch a bid as traders calculated the rebalancing within a shrinking pool the loss of MMP would cause for AMLP. The OKE-MMP transaction is looking less likely, as explained later in this blog post.

Nonetheless, AMLP is still the sector’s biggest ETF by a considerable margin. That AMLP retains any holders is confirmation that inertia and benign tolerance still inform investment decisions for some.

November’s tax-based NAV correction wasn’t the advisor’s last word on the issue. Last week they provided a tax update that, “modified the estimate of the Fund’s deferred tax liability” by $188 million, an additional 2.27%.

This will push AMLP’s five year underperformance against an index that has itself severely lagged midstream energy infrastructure to close to 3%.

Since November, AMLP’s NAV has been adjusted down by over 6% as Alps hopes it has finally got its arms around the complex tax issues the fund faces. Their lawyers, who will have carefully drafted the latest press release, wisely added, “The Fund’s estimates regarding its deferred tax liability are made in good faith; however, the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.”

In other words, there could be more to come.

There must exist a hardcore group of AMLP investors who resemble the reliable and extreme primary voters of either political party. They accept their flawed choice with no regard for continued evidence of his (her) failings, because to change now would mean conceding an earlier error. There is no helping these investors. They fork over $50 million in management fees annually to an advisor who has now made two tax errors equal to multiples of that.

But there also exists a swathe of financial advisors holding AMLP for clients whose fiduciary fitness can be questioned by having selected such a poorly run, anachronistic fund. You may be one of these advisors, or you may be a client of one. $405 million of tax-related restatements is starting to look like a situation best avoided. Perhaps a class action lawsuit will seek to restore some of those losses out of past management fees.

AMLP now reports a Deferred Tax Liability (DTL) of $373 million (as of June 2, 2023). Market appreciation will create additional unrealized gains and an increased DTL, which will act as a headwind in a rising market.

The case for not owning AMLP could not be clearer. In fact, its best use may be as a short position, as we’ve noted in the past (see Uncle Sam Helps You Short AMLP).

.avia-image-container.av-19ctqux-555d1a394f7b29d9d74be6f0775cb836 img.avia_image{ box-shadow:none; } .avia-image-container.av-19ctqux-555d1a394f7b29d9d74be6f0775cb836 .av-image-caption-overlay-center{ color:#ffffff; }

Investors in OKE and MMP will be encouraged to see a widening spread between MMP’s price and the value of OKE’s proposed acquisition. This means traders are increasingly skeptical that the deal will get done. Since the announcement on May 12, OKE is down 8% and MMP is up only 11%, half the promised premium. The AEITR is +2.5%. It’s one of those rare transactions that is bad for both sides (see Oneok Does A Deal Nobody Needs). OKE gets higher leverage and MMP investors face an unwelcome tax bill.

.avia-image-container.av-jh2d4p-5bd0cddb16b1e36301a5b3b264abce34 img.avia_image{ box-shadow:none; } .avia-image-container.av-jh2d4p-5bd0cddb16b1e36301a5b3b264abce34 .av-image-caption-overlay-center{ color:#ffffff; }

Hopefully it’ll get voted down. We calculate the market-implied odds of it going through are now barely above 50/50*.

.avia-image-container.av-thi6rd-ff00dc8a545914d4c1850b78c53cc7f1 img.avia_image{ box-shadow:none; } .avia-image-container.av-thi6rd-ff00dc8a545914d4c1850b78c53cc7f1 .av-image-caption-overlay-center{ color:#ffffff; }

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

*The probability of the deal happening is estimated as follows:

Let:

MMP = current price of MMP

MMPD = price of MMP implied by deal

MMPND – the price MMP would drop to if the deal was canceled, which is assumed to be its pre-deal level adjusted for subsequent move in sector as defined by AEITR.

Deal Probability, or DP = (MMPD-MMP)/(MMP-MMPND)

Therefore, odds of No Deal = 1-DP

Consumer sentiment is as bad as 1980 when inflation was 13%. The Fed funds rate swung from 17% to 9% before peaking at 19% in early 1981. Eight US marines died in Iran in a failed attempt to rescue our hostages. John Lennon was shot. No wonder Ronald Reagan won election later that year. Consumers today are more negative than they were back then.

The put/call ratio is close to the extremes of the Great Financial Crisis in 2008 when Bear Stearns was bailed out by JPMorgan and Lehman failed. There’s plenty of negatives, but are prospects really that terrible?

.avia-image-container.av-32oyxwv-301916881eb8f396de672b3e9ad1e1cc img.avia_image{ box-shadow:none; } .avia-image-container.av-32oyxwv-301916881eb8f396de672b3e9ad1e1cc .av-image-caption-overlay-center{ color:#ffffff; }

If you’re not yet convinced of pervasive bearishness, how about that for the first time in 25 years US equity strategists are forecasting a down year.

.avia-image-container.av-2owsacv-63dbb5ed4be8efe05277b5afb6177f63 img.avia_image{ box-shadow:none; } .avia-image-container.av-2owsacv-63dbb5ed4be8efe05277b5afb6177f63 .av-image-caption-overlay-center{ color:#ffffff; }

Conventional portfolios did poorly. Diversification and a dollop of fixed income have caused misery. Energy and cash was the improbable winning combination. Meme stocks, tech and bitcoin (useless except when it’s going up) have slumped along with animal spirits.

.avia-image-container.av-1z8rjhr-751a0d2bba234043a48613fad743e638 img.avia_image{ box-shadow:none; } .avia-image-container.av-1z8rjhr-751a0d2bba234043a48613fad743e638 .av-image-caption-overlay-center{ color:#ffffff; }

But everyone who wants a job has one, albeit pay is lagging inflation. We’re not at war, although between Ukraine and Taiwan there’s plenty to worry about. And it looks like we handled covid rather better than China even though they had a head start on us since it originated there.

If today’s outlook compares unfavorably with 2008 or 1980, you have to conclude that people expect more out of life. Warren Buffet famously said that the secret to a happy marriage is to marry someone with low expectations. At moments of marital discord, I’ve pushed my luck by sharing this wisdom with my wife, who retorts that her expectations couldn’t be any lower.

Perhaps happiness in life requires lower expectations than evidenced by survey respondents to the University of Michigan.

The Alerian MLP ETF (AMLP) may be a flawed investment product, but it still has its uses. It serves as a reminder of what an ETF should not be, which is a payer of corporate taxes. As regular readers know, AMLP doesn’t qualify to be exempt from taxes like virtually all ETFs and mutual funds, because it invests almost all its assets in MLPs. Our Byzantine tax code recently led to a 3.9% NAV hit for AMLP investors as its advisor Alps reassessed what they owed (see AMLP Trips Up On Tax Complexity).

AMLP is inadequate as a long-term investment because its taxable structure ensures it will substantially lag its index. But it can still be worthwhile as a short. One example is when market appreciation turns unrealized losses into gains. Upon crossing that threshold the tax drag kicks in, such that it goes up at 79% of its index (ie 1 – the 21% corporate tax rate) but still falls with the market. Such asymmetry can make it a useful hedge on a long portfolio of MLPs or even a good short position (see Uncle Sam Helps You Short AMLP).

.avia-image-container.av-1rmnkkv-968774647f315698e7fa09e47cc07a12 img.avia_image{ box-shadow:none; } .avia-image-container.av-1rmnkkv-968774647f315698e7fa09e47cc07a12 .av-image-caption-overlay-center{ color:#ffffff; }

Another trade opportunity exploits the January effect. This used to be a feature of the S&P500 but has disappeared in recent years. It’s not that pronounced for the American Energy Independence Index (AEITR), but still shows up in the Alerian MLP Infrastructure Index (AMZIX), which AMLP seeks to track minus the tax drag and expenses.

.avia-image-container.av-138prxr-83b9b9cdb993b9521293198a85c49a73 img.avia_image{ box-shadow:none; } .avia-image-container.av-138prxr-83b9b9cdb993b9521293198a85c49a73 .av-image-caption-overlay-center{ color:#ffffff; }

The likely reason for a positive start to the year is that MLP holders tend to be K-1 tolerant, US taxable Americans. Because K-1s are a pain in the neck, if you’re contemplating selling an MLP December is better than January because you’ll avoid one last K-1 for the stub year. Similarly, purchases delayed until January avoid a K1 for the last month of the prior year.

Over the past decade, the AMZIX has averaged +3.3% in January, versus 0.5% for all months. Seven out of ten Januarys were positive, and only one was down more than 5% (2020). On average it’s up around half the time. If you’re inclined towards trading, buying AMLP now and planning to exit next month has an attractive risk/reward. And if you’re thinking of investing in the sector, delay is likely to mean paying higher prices. Just don’t make AMLP a long-term holding, because with its tax structure and absence of the biggest pipeline corporations it’s likely to continue underperforming the sector.

The seasonal January AMLP trade might benefit from a macro backdrop that suggests more investors than usual are hedged, defensive, in cash and hunkered down. In addition, the fundamentals for midstream energy infrastructure remain positive as tirelessly reported on this blog (see Energy – The Only Bright Spot In 2022). And if you already own AMLP, late January could be your best chance to swap it for a fund with a more investor-friendly structure.

.avia-image-container.av-uasp5b-5f02161df66d292d7eccd3a72b548d9a img.avia_image{ box-shadow:none; } .avia-image-container.av-uasp5b-5f02161df66d292d7eccd3a72b548d9a .av-image-caption-overlay-center{ color:#ffffff; }

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

We all know the US tax code is complicated. ALPS Advisors, manager of the Alerian MLP ETF (AMLP), has been tripped up by the tax complexities inherent in their fund structure. As a result they’ve been forced to make an embarrassing NAV adjustment to AMLP for taxes, depressing the fund’s NAV by almost 4%. It must be frustrating for recent buyers, since it shifted the fund to a 2.7% monthly loss, 3.9% behind its index.

AMLP is that rare ‘40 Act fund that pays corporate tax. Under the 1940 Investment Company Act, mutual funds and ETFs, which are corporations, can qualify to be RICs (Regulated Investment Companies) and therefore be exempt from corporate tax if they meet certain rules. These include being fully invested in securities, meeting certain diversification thresholds and so on. Almost all such funds qualify. Investing more than 25% of your assets in Master Limited Partnerships (MLPs) fails the test to be a RIC.

.avia-image-container.av-1mjtcme-1ebf25c0c3e79ea87ba76155d0bd8dad img.avia_image{ box-shadow:none; } .avia-image-container.av-1mjtcme-1ebf25c0c3e79ea87ba76155d0bd8dad .av-image-caption-overlay-center{ color:#ffffff; }

AMLP holds MLPs because in 2010 when it was launched, midstream energy infrastructure businesses were mostly MLPs, not corporations. AMLP provides a way for retail investors who don’t want K1s to invest in MLPs – but at the cost of lower returns because AMLP first pays corporate taxes on its realized returns before making distributions to its investors. We’ve written about this in the past (see  AMLP’s Tax Bondage and Uncle Sam Helps You Short AMLP).

An MLP-dedicated portfolio is out of touch with today’s sector, since many MLPs have converted to be corporations. The pool of money willing to invest directly in MLPs is limited to K1-tolerant US taxpayers – older, wealthy Americans. US equities are overwhelmingly held by institutions such as pension funds, endowments, foundations and sovereign wealth funds. These investors are mostly exempt from US taxes, so they avoid MLPs because it would create a tax liability for them. Only two of the ten biggest North American pipeline businesses are MLPs – the rest are corporations.

Several years ago the Federal Energy Regulatory Commission (FERC) announced a change in how their expenses were calculated that was adverse to natural gas pipeline MLPs. Taxes owed by their investors used to be included in the operating costs on which MLPs based their tariffs. FERC’s new rule would have lowered revenues, so natural gas pipelines soon converted to corporations to sidestep the issue.

It’s another example of the tax complexity that comes with MLPs. Although FERC later modified their stance, today’s MLPs tend to be (i) more liquids/less natural gas oriented, (ii) smaller, and (iii) more levered. The pipeline sector and MLPs are no longer synonymous.

AMLP has stuck with MLPs despite their shrinking relevance. If they considered diversifying into corporations this would put downward pressure on their current holdings, depressing their NAV and alarming investors. They’d need to obtain shareholder approval for this change of strategy and doing so would signal to the market an impending seller of MLPs. Many investors use AMLP to achieve pipeline exposure and, in our experience, few consider either the dwindling number of MLPs or the tax drag on returns. If AMLP was created today it would include pipeline corporations, in order to reflect the entire industry. It is an anachronism.

It now appears that AMLP investors must consider tax uncertainty on top of the haircut this imposes on returns. In their press release ALPS Advisors blames the NAV reduction on tax legislation passed in 2017, as well as the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), which was passed in March 2020. The problem is not recent.

.avia-image-container.av-3svzmu-33644b5c0c4c1c4720cac305008bb596 img.avia_image{ box-shadow:none; } .avia-image-container.av-3svzmu-33644b5c0c4c1c4720cac305008bb596 .av-image-caption-overlay-center{ color:#ffffff; }

AMLP’s tax liability is updated daily, which suggests some certainty around its calculation. It looks as if ALPS had to modify their interpretation of the tax code, resulting in the sudden 3.9% NAV reduction. It must be complicated. Going forward, investors can no longer rely on the published tax liability. The press release warns that, “the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.”

In other words, if ALPS gets their tax math wrong again, investors might face another big NAV adjustment. Because AMLP is a tax-paying entity and the tax code is fiendishly complicated, you can’t rely on the NAV being accurate.

Over the past five years, AMLP has significantly lagged the midstream energy infrastructure sector, because MLPs have lagged corporations and been more likely to cut their distributions. Investor inertia has presented little reason for any changes but lagging performance and now uncertain tax expense leave little here for the discerning investor.

.avia-image-container.av-jfc6ti-c57c220c9f7cf82e2d28bfb5257bd4aa img.avia_image{ box-shadow:none; } .avia-image-container.av-jfc6ti-c57c220c9f7cf82e2d28bfb5257bd4aa .av-image-caption-overlay-center{ color:#ffffff; }

A few weeks we posted Bad Investment Ideas Still Flourish (Part 1). The current plethora of products injurious to one’s financial health assured enough material for Part 2.

ESG

Like many Wall Street fads, Environmental, Social and Governance (ESG) standards started out as a good idea before being used to exploit the naïve and those with rigid investment mandates. Individuals whose lives are guided by ESG possess personal qualities likely to make them worth knowing and may even be good for the planet too. But quantifying a friend’s good humor or generosity is no easier than measuring a company’s ESG-ness.  This made it a fertile environment for index providers and fund managers purporting to count the uncountable and charge for identifying it.

Not surprisingly, every company can find some independent third party to testify that they’re ESG. If Lockheed Martin can make it on to such a list, the standard must be infinitely malleable. The consequent growth in ESG has relied on equal measures of Wall Street cynicism and investor gullibility. In a world of only tall people, nobody is tall. If every company can find someone to give them a high ESG rating, there are no low ones and ESG is meaningless. It’s been a solution searching for a problem (see ESG is a scam). By way of penance and in search of the next profit opportunity, a swathe of anti-ESG funds must be coming soon. At least those investors will be appropriately cynical.

Hedge Funds

Lotteries offer ticket buyers a negative expected outcome but nonetheless succeed because from the moment of purchase until the drawing, buyers enjoy the hope of a life-changing win. The utility they derive from imagining how they’ll spend their winnings supports the profit margin of such enterprises. They are regressive too – the portion of income spent on lottery tickets falls as income rises.

The hedge fund industry shares with lotteries the sale of hope in defiance of the historical record to investors. Hedge fund indices present a relentless history of failure to meet expectations. Their promoters have cleverly shifted the goalposts from absolute returns (shown to be unattainable) to relative returns (relatively worse than almost anything else) to uncorrelated (ie nowhere close to the S&P500). Investors have gamely clung to the belief that superior qualitative human judgment will allow them to avoid disappointment, overlooking that a manager who is smarter, richer and probably better looking is likely to have more to show from the relationship at its conclusion.

My 2011 book The Hedge Fund Mirage; The Illusion of Big Money and Why It’s Too Good To Be True showed why, “If all the money that’s ever been invested in hedge funds had been in treasury bills, the results would have been twice as good.” It remains true today that there are too few good hedge funds to justify the assets available to them.

MLP-dedicated funds

When Master Limited Partnerships (MLPs) were the dominant corporate form for midstream energy infrastructure (oil and gas pipelines, storage assets etc), ‘40 Act funds were created to offer the retail investor exposure while shielding them from the hated K1s MLPs issue in lieu of 1099s. Uniquely, MLP funds accept the obligation of paying corporate taxes on their returns, a burden so uncommon that many investors remain unaware of it even today (see MLP Funds Made for Uncle Sam).

The need for MLP-dedicated funds passed years ago (see MLPs No Longer Represent Pipelines), as most big MLPs converted into regular corporations to be more attractive to investors, including institutions who largely shunned them. Today’s MLP-dedicated fund is limited to around a third of the pipeline sector, and relative to the broad-based American Energy Independence Index must accept less natural gas, more junk issuers and smaller median market cap. If they didn’t exist, nobody would create MLP-dedicated funds today. But inertia is a powerful force among existing investors. For the funds, restoring their original mandate to invest in the overall sector would signal the impending sale of current holdings so as to buy the biggest pipeline corporations, depressing NAVs and upsetting investors. Like fish in a drought-ravaged pond, they flop around their decreasing opportunities.

A special place in investment purgatory awaits the managers of MLP-dedicated closed end funds, who saw fit to add leverage to already undiversified portfolios. When an industry’s CFOs and rating agencies have agreed on a Debt:EBITDA ratio of 4X, it takes supremely misplaced self-confidence to reject such judgment by adding fund-level leverage to reach 5.5X (see MLP Closed End Funds – Masters Of Value Destruction). The March 2020 crash in pipeline stocks relied in part on the untimely deleveraging of these vehicles, a Darwinian result that left them appropriately diminutive with a much reduced ability to wreak such havoc in the future.

Conclusion

In ranking the bad investment ideas including those from Part 1 Bitcoin, Bonds, Climate Change politics and Emerging Markets, measured by damage inflicted there is no competitor to Bonds. An entire asset class has gone from years of providing merely paltry returns to now inflicting capital losses too. In 2013 my book Bonds Are Not Forever: The Crisis Facing Fixed Income Investors explained why low yields insufficient to compensate for inflation were likely to persist. If ever an entire asset class should be abandoned as not fit for purpose, this would be it.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The continued rally in the energy sector is steadily lifting past performance ahead of the S&P500 over multiple timeframes. The American Energy Independence Index (AEITR) now has a higher annual return than the S&P500 over the past one, two and three years. Even over five years the performance gap is closing. The 12.3% pa return on the S&P500 is 3.1% ahead of the AEITR. On the Covid low (3/18/20), the AEITR five year trailing return was –19.2% pa, 23.9% worse than the S&P500. It was a dark moment indeed for pipeline investors, and especially so for those focused on MLPs where the carnage was even worse. 

The subsequent recovery has produced some striking relative performance. The one and two year trailing performance figures cause some potential investors to question whether such a move will assuredly be followed by a collapse.  

.avia-image-container.av-4ke70k-4bc80664e338e19ec18d88acee5c0e1c img.avia_image{ box-shadow:none; } .avia-image-container.av-4ke70k-4bc80664e338e19ec18d88acee5c0e1c .av-image-caption-overlay-center{ color:#ffffff; }

The fundamentals remain very good. 1Q22 earnings generally beat expectations, in some cases (ie Cheniere) by a huge margin. Financial discipline continues to constrain growth capex, aided by pipeline protesters whose efforts further dissuade spending on new projects. Hug a protester and offer to drive them somewhere. 

The Covid recession and recovery dominate recent performance history. But it’s worth remembering that the pipeline industry had already shifted away from spending for growth in favor of increasing free cash flow before that. By late 2019, pre-Covid, we felt the sector was poised to outperform because the growth years and MLP distribution cuts of the Shale Revolution had alienated so many investors.  

Two months ago, the pre-Covid return (ie from 12/31/2019) on the AEITR moved ahead of the S&P500. As of Thursday, the AEITR is 8.3% ahead of the market. Surging inflation and Europe’s sudden desire for energy security are two important tailwinds for energy stocks. But the sharp drop and quick recovery that Covid inflicted on the pipeline sector is looking increasingly aberrant. It will always be part of the sector’s history. Becoming comfortable that it won’t repeat is a hurdle facing many potential new investors.  

Closed End Funds (CEFs) have a longer history of providing MLP exposure to retail clients than even the deeply flawed Alerian MLP ETF (AMLP, see MLP Funds Made for Uncle Sam). For example, the Cushing MLP & Infrastructure Total Return Fund (SRV) sports an inglorious fifteen year history of relentless capital destruction. It now trades at less than one tenth of its IPO price. In 2015 we were moved to note its sorry eight year performance of delivering less than a quarter of the return of its benchmark (see An Apocalyptic Fund Story). Although consistent performance has rendered its diminutive size ($70 million AUM) no longer a significant source of revenue to manager Swank Energy Income Advisers, it still serves to warn CEF investors of the damage leverage and poor management can inflict.  

CEFs were generally not a big factor in the Covid bear market, but they did play an outsized role in the MLP collapse, which hurt the entire midstream sector. Operating a single sector fund with leverage reflects an opinion that the companies in that sector should be operating with more debt than they currently do. In effect, it’s a rejection of the collective wisdom of all the CFOs and rating agencies that have arrived at the prevailing capital structure in use.  

.avia-image-container.av-vwlv50-9f0baf2d54aa71d6d6bd69a9f69469f6 img.avia_image{ box-shadow:none; } .avia-image-container.av-vwlv50-9f0baf2d54aa71d6d6bd69a9f69469f6 .av-image-caption-overlay-center{ color:#ffffff; }

Since the stocks within a sector will tend to be highly correlated with one another, there’s little diversification benefit which might otherwise justify the increased risk profile. Single sector closed end funds use leverage to increase the dividend they can pay. But maintaining that leverage requires them to add to their holdings in a rising market – and to reduce them in a falling one. 

When MLP prices collapsed in March of 2020, MLP CEFs had no choice but to delever, which required selling. They exacerbated the fall in prices for the pipeline sector.  

The reason investors shouldn’t expect a repeat is because the consequent value destruction left all the MLP CEFs smaller. They’re no longer managing as much money, because of locked in losses, so wouldn’t have as much to sell even if we endured a repeat of March 2020. The managers of sector-specific CEFs with leverage combine poor judgment with hubris. They include Goldman Sachs, Tortoise, First Trust and Swank.  

Many MLP CEF holders who hung on in the belief that what falls so far must surely rebound will have been disappointed. The 17 MLP CEFs listed on Nuveen’s website are on average still down 37% from their level at the end of 2019, pre-Covid. The AEITR has fully recovered its losses with an 18.5% pa positive return. 

The two lessons are: (1) don’t invest in single sector CEFs because the leverage will eventually create permanent losses, and (2) because MLP CEFs provided evidence of #1 in 2020, they can’t repeat. So prospective investors in midstream energy infrastructure can regard the worst of the March 2020 brief collapse in pipeline stocks as unlikely to repeat.  

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last week the Alerian MLP and Infrastructure Total Return Index (AMZIX) finally recouped its Covid losses. MLPs have returned to where they were at the end of 2019, when few knew what a coronavirus or N95 mask was. MLP investors have had a miserable decade. The Shale revolution turned out to be an investment bust through overinvestment; the energy transition cast a growing shadow over terminal values; finally, Covid hit demand. As if this wasn’t bad enough, MLP closed end funds endured what leverage and a big market drop inflict (see MLP Closed End Funds – Masters Of Value Destruction).

.avia-image-container.av-mkp8l-45c6c2a95809f1ce22285599dcecc652 img.avia_image{ box-shadow:none; } .avia-image-container.av-mkp8l-45c6c2a95809f1ce22285599dcecc652 .av-image-caption-overlay-center{ color:#ffffff; }

Although MLP investors can celebrate finally recouping their Covid losses, North American pipelines (which are mostly corporations, not MLPs) reached this threshold three months earlier. Energy is experiencing one of the least celebrated rallies of any sector in recent memory. Few investors will forget the breathtaking drop of March 2020, which at one point registered down almost 60% for the year. Although no pipeline company ever looked remotely close to bankruptcy, it seemed as if a recovery would take years.  

.avia-image-container.av-1411y05-e40ebf88e13b10c2ddd06251afbdba03 img.avia_image{ box-shadow:none; } .avia-image-container.av-1411y05-e40ebf88e13b10c2ddd06251afbdba03 .av-image-caption-overlay-center{ color:#ffffff; }

The rebound has turned out to be more rapid than many expected. It’s taken a year, but fund flows have now turned positive. These are still not meme stocks so caution prevails. But the growing free cash flow story is drawing more interest. The energy transition is driving oil and gas prices higher as well as limiting growth capex. Several firms are exploring opportunities in Carbon Capture and Sequestration (CCS). Gathering the CO2 where it’s produced by power plants or the manufacture of steel and cement may offer new opportunities. The tax code will soon pay $50 per ton for CO2 permanently buried underground. Pipeline operators possess many of the required skills and some useful infrastructure.  

Moreover, green policies are helping (see Profiting From The Efforts Of Climate Extremists). While Exxon Mobil, Chevron and Royal Dutch Shell all received clear direction to further curb emissions, Tellurian (TELL) showed that global demand for U.S. Liquified Natural Gas (LNG) is vibrant, and probably stronger with the biggest oil and gas companies set to invest less in future supply. TELL has recently signed 10-year agreements to provide LNG to Gunvor and Vitol, two commodities firms that see a benefit in securing supplies now for customers in Asia and elsewhere.  

Investors are slowly warming to the positive fundamentals. MLPs long ago stopped being the dominant corporate form in the pipeline sector. Beyond the three big ones, Enterprise Products Partners, Energy Transfer and Magellan Midstream, MLPs offer a selection of mostly non-investment companies. The AMZIX has to limit the biggest names because there are too few to create a diverse portfolio.  

.avia-image-container.av-ues8kl-7fda4664e68ba1db4c9df52e7f7b0ec9 img.avia_image{ box-shadow:none; } .avia-image-container.av-ues8kl-7fda4664e68ba1db4c9df52e7f7b0ec9 .av-image-caption-overlay-center{ color:#ffffff; }

MLPs are now around a third of the North American midstream infrastructure business (as defined by the American Energy Independence Index, AEITR), and performance has lagged over numerous timeframes. MLP distributions on the Alerian MLP ETF (AMLP), which invests in AMZIX, have been cut by more than half over the past five years. The K-1 tolerant high net worth U.S. taxable investor has for the most part abandoned MLPs, although some remain because of the tax-deferred nature of the distributions. Corporations have handily outperformed MLPs because of the broader investor base.  

For years, AMLP’s status as a tax-paying corporation caused it to lag its index. At times this creates asymmetry – when it has unrealized gains its upside is held back by taxes, but when it has unrealized losses it falls with the market. Shorting AMLP around this inflection point can be an interesting trade, one your blogger has done in the past (see Uncle Sam Helps You Short AMLP).  

In recent years MLPs have performed so poorly that AMLP has been a long way from having to carry a deferred tax liability. But if the sector’s current trend continues, it will once again become a taxpayer and fail to track its index. And if Democrat proposals to raise the corporate tax rate are enacted, the tax drag will be even more expensive.  

We’ve started to see investors once again switch out of AMLP and into more tax-efficient, RIC-compliant vehicles. They recognize that the pipeline sector is attractive, but they’re in the wrong product.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Stephanie Kelton’s The Deficit Myth opens with the startling assertion that the only reason today’s fiat currencies have any value is because citizens need to acquire them to pay taxes. Without that requirement, there would be no need to hold dollars, euros or yen. I first heard this argument from Warren Mosler twenty five years ago when he was a partner in hedge fund Illinois Income Investors in West Palm Beach. I found this view quixotic at the time, although our meeting was too brief to fully refute it. Today Mosler is regarded as the father of Modern Monetary Theory (MMT), seized by progressive Democrats as evidence that the Federal government can pay for everything.

To prove that tax liabilities are necessary to give money value, Kelton recounts a story I heard personally from Mosler in the 1990s. Suppose he assigned household chores to his children with payment promised in business cards. With little of value being offered in exchange for the work, the lawn would remain uncut and the car unwashed. But if Mosler the Dad then imposes a monthly tax of 30 business cards from each offspring, on pain of being grounded, they suddenly have value. The work gets done.

From this follows the logic that the government needs to spend money in order to provide the means with which to pay taxes. The government, as the sole issuer of currency, can pay in regular green dollars, or in yellow interest-bearing dollars (i.e. they can borrow to pay their bills). They can never run out. So they can never go bankrupt. Therefore, deficits don’t matter unless they exhaust the economy’s productive capacity, which is inflationary.

I’m still not convinced taxes are necessary to give a fiat currency value, although behind every such currency lies a government taxing and spending it. For much of human history money has been linked to gold. When the US left the gold standard in 1971, the severing of the link ushered in fiat currencies that derived their value from the issuing country’s policies. But it’s definitely clear that a country can never be forced into bankruptcy in its own fiat currency, as they can always issue an unlimited amount to pay their bills. In this narrow sense, debt doesn’t matter.

So far, this is a non-partisan exercise in economic theory.

Kelton then seizes the access to unlimited credit to gorge on a left wing dream of largesse. Trillions of dollars are breezily allocated to student loan forgiveness, upgrading our infrastructure, fighting climate change and dealing with the pandemic. Because the Federal government can never go bankrupt, deficits don’t matter. The twin looming crises of social security and Medicare don’t matter, because the government will spend whatever it needs to, since its ability to borrow in its own currency is unlimited.

It sounds implausible, but here Kelton misses the opportunity to strengthen her case. Today, America’s fiscal outlook provokes widespread hand wringing and dismay. Retiring baby boomers will command an unsustainably growing chunk of Federal spending. There is nothing remotely optimistic to be said on the topic. Yet long term government bond yields remain defiantly low. The empirical evidence that deficits don’t matter exists in Uncle Sam’s continued ability to fund its needs at rates below inflation. An even more brazen MMT advocate would argue low bond yields are the market’s vindication that deficits don’t matter.

The failure of conventional economic thinking to explain apparently costless fiscal profligacy offers at least an opening for the progressives who have hijacked MMT to drive through. Kelton misses her chance.

The risk is of course inflation. If the government tries to pay for more output than the economy is able to provide, inflation will follow. If Mosler the Dad started adding new chores, he’d have to offer more business cards per hour to motivate his exhausted children. Had his progeny begun saving these cards for the future, the resulting inflation would diminish their value. Kelton does admit to limits on spending, but these are imposed by inflation not deficits. She argues that government spending should rise until it’s inflationary, ensuring maximum utilization of the economy’s potential.

That is in effect current policy, administered by the Federal Reserve’s twin objectives of maximum employment consistent with stable inflation. Kelton would prefer the Federal government was explicitly responsible for the twin mandate rather than the Fed. In doing so they would rely on fiscal, rather than monetary policy.

Since inflation has remained so consistently low that the Fed is trying to overshoot its 2% target, it’s a reasonable argument that pursuing NAIRU (the Non-Accelarating Inflation Rate of Unemployment) through interest rate policy alone is leaving millions of potentially productive people out of the labor force. The Fed can be criticized for over-estimating NAIRU, but there’s no reason to think Congress would do any better. They would inevitably synchronize economic booms even more closely with the election cycle, and there would be no reason to expect anything but a bad outcome. This is why independent central banks are part of every well-run economy.

However, Kelton goes further, advocating government spending until everyone has a job, supported by a Federal jobs program for all. “The federal government announces a wage (and benefit) package for anyone who is looking for work but unable to find suitable employment in the economy.” she writes.

Kelton’s faith that a huge program of useful jobs could be run productively without abuse is naive. Would the government fire lazy workers? Under her approach, “It takes workers as they are, and where they are, and it fits the job to their individual capabilities and the needs of the community.”

It would descend into a jobs program for those unemployable in the private sector. Don’t MMT advocates even believe in workers learning marketable skills?

Many questions are left unanswered. Most obviously, what would the Federal government do when its spending caused inflation? If the ability to issue debt in your own currency is so valuable, why do countries give up sovereignty and join currency unions, such as the euro, or peg their currency to the dollar? What does MMT say about serial defaulters like Argentina? What about Germany’s hyperinflation that preceded the rise of Hitler? And while Kelton argues we should not worry about future entitlement obligations, what would MMT prescribe if those future payments ultimately drive up inflation? She fails to identify a single country that has successfully relied on deficits to maximize economic output.

MMT has become shorthand for unlimited government spending to solve every problem progressives can identify. Stephanie Kelton’s expansive vision of MMT’s possibilities cemented the conviction of many that our economy needs protection from the more liberal elements of Joe Biden’s party. It’s the type of thinking that denied Democrats a stronger electoral showing. Warren Mosler is rich enough to indulge such economic fantasies today, but I doubt 25 years ago he would have favored big government on such a scale.

In Lunch with the FT, journalist Brendan Greeley was disappointingly deferential. There’s little insightful in Kelton’s policy prescriptions. The type of profligate government spending she advocates has invariaby led to ruinous inflation elsewhere. If practised here, progressives would likely blame a Wall Street conspiracy for the economic destruction they had wrought. MMT isn’t a new idea, and isn’t a new source of money for liberals to spend. It should drift from the fringes of policy discussion to complete oblivion.

MLPs have been losing relevance to the midstream energy infrastructure sector for years. The Shale Revolution caused them to evolve from reliable generators of income to growth-seeking enterprises. As upstream companies plowed money into drilling, pipeline companies felt compelled to add new infrastructure to service them. The capital spending spigot had already been ratcheted down since 2018, with investors rebelling against the culture of always building. The hit to demand from Covid accelerated a trend already in pace.  

.avia-image-container.av-wl4usz-b12b324fc193f1b3077e571fef8d8b98 img.avia_image{ box-shadow:none; } .avia-image-container.av-wl4usz-b12b324fc193f1b3077e571fef8d8b98 .av-image-caption-overlay-center{ color:#ffffff; }

MLPs represent around a third of the pipeline business. This has left MLP-dedicated funds increasingly challenged to find enough names to build out a portfolio. It’s a dilemma we’ve forecast for a long time (see The Uncertain Future of MLP-Dedicated Funds, April 2018). Such funds, most notably the Alerian MLP ETF (AMLP), were already burdened with an inefficient structure (see Uncle Sam Helps You Short AMLP, July 2018).  

The MainStay Cushing MLP Premier Fund (CSHAX) has decided to bite the bullet and abandon their anachronistic structure. In recent weeks they’ve been quietly informing clients that they plan to limit MLPs to 25%, because of the “significant contraction” of MLPs. It’s taken them longer than it should, but they’ve accepted that the MLP business has changed. Serial distribution cuts imposed on income seeking investors have lost those investors to the sector for good.  

CSHAX is around $500MM in AUM. Bringing their MLP holdings below 25% will require them to shed 75% of their portfolio, around $375MM, over period of months. MLP funds have seen around $6BN of outflows in the past year, and this has weighed on prices. Even so, the CSHAX repositioning should be manageable. 

But what if other MLP funds reach the same conclusion? The Invesco Steelpath family of MLP funds is over $3.5BN. Center Coast and Goldman each have another $800MM. And AMLP is $3.3BN. There’s over $13BN invested in flawed, MLP-dedicated funds.  

MainStay Cushing’s move is logical, but nobody will want to be the last one jumping. They’re not the first either. Some smaller closed end funds have combined and become RIC-compliant by limiting MLPs to 25%. The Kayne Anderson MLP/Midstream Investment Company recently became the Kayne Anderson Energy Infrastructure Fund (still KYN). Dropping MLPs is a developing trend. 

It should induce investors in all MLP-dedicated funds to ponder their fund’s future. If bigger funds follow MainStay Cushing, the MLP sector could find itself having to absorb an indigestible amount of sales. Alerian calculates the market cap of MLPs at $139BN, but it’s only $72BN when adjusted for float. For example, the Duncan family’s 32% ownership of Enterprise Products Partners (EPD) doesn’t provide any liquidity. The remaining MLP-dedicated funds are almost 20% of the market. 

MLPs are cheap by any reasonable measure. We’ve noted the yawning gap between EPD’s debt and equity yields (see Stocks Are Still A Better Bet Than Bonds). Bond and stock investors are poles apart in their assessment of the sector. But the risk investors in MLP-dedicated funds face is that portfolio shifts by competitor funds depress MLP prices, driving down their own fund’s NAV. 

The near–term future of MLP-dedicated funds is unclear. But the time for such vehicles has passed, and it seems inevitable that funds invested in midstream infrastructure will limit MLPs to 25%. You just don’t want to be in the last fund to decide to make the shift.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.