I’m sitting at the Strip House with a wholesaler from a large mutual fund / UIT sponsor two years ago. He’s a good guy but he’s there to sell. I’m there to eat thick-cut slab bacon and shrimp cocktail. I told him in advance that I’m not a buyer, but I have an open mind.
He’s showing me an SMA (separately managed account) strategy whereby his firm’s team of experts picks the best MLPs. The pitch is that MLPs are a way to participate in the growth of energy infrastructure but without having exposure to the volatility of oil prices. MLPs, he explains, are uncorrelated to the price of oil because they act like “toll collectors”, earning money based on the flow-through of oil, regardless of what a barrel of the stuff ends up selling for on the spot market.
Last fall, a gentleman from one of the largest investment banks on The Street meets me at a Bar Mitzvah. A week later he’s in my conference room pitching me an MLP fund as a bond substitute. It’s better than traditional fixed income because it stands a better chance of competing with rising rates. “As the economy gets better, MLPs are dealing with higher volumes and thus they can pass on higher income from their increased cash flows. Bonds, with their fixed coupons, cannot do that.”
These scenes have played out at lunch tables, conference rooms, investment committee meetings and due diligence sessions around the country for years now. MLPs are a huge pain in the ass tax-wise, but we are told that the need to file K-1s is a minor annoyance given the many benefits of being in the asset class, namely:
a) low correlation to regular oil stocks
b) bond-like characteristics
c) limited exposure to the volatility of energy prices
It’s a great story. If only it wasn’t complete and utter bullshit.
2015 has seen these and other MLP myths blown to smithereens.
Simon Lack details the carnage for this supposedly insulated, uncorrelated sector:
the use of MLPs as a fixed income substitute has not looked so clever of late. The asset class sported a -32% total return from its peak a year ago until very recently. Following a modest bounce, MLPs are now 28% off their all-time highs (including distributions), and -17% YTD. Only 2008 was a worse time to be an MLP investor, and pretty much everything was going down then whereas the broader equity indices are currently close to all-time highs. So one must concede that the case for using MLPs as a fixed income alternative has been weakened as a result of their correlation with crude oil and its concurrent 50% slide.
Lack is turning positive on the space. He notes that there are now 7%-plus yields available in the asset class, combined with the fact that the partnerships have continued to increase their distributions in the face of a horrible industry backdrop.
Maybe he’s right. My point today is not to pass judgment on the whole MLP complex and say that these investments are either “good” or “bad”. Rather, I’m here to relay some important lessons learned from what’s gone on in the space.
The first lesson is that “in theory” doesn’t do you any good when you’re living and investing in the real world. In theory, MLPs should not be overly sensitive to oil prices because they themselves are not making a bet on the future price of the commodity, just the continued need for distribution. What the theorists didn’t factor in is that MLPs are susceptible to an oil rout because the industry relies on continued financing in the bond market and when creditors get skittish, everyone’s cost of borrowing goes up.
The second lesson is that multiple expansion or contraction is not a fundamental phenomenon, it is a sentiment phenomenon. A business can see no change in its underlying fundamentals – it can even see an improvement – but this is not the determinant of what investors might be willing to pay for those fundamentals. MLPs, like stocks, commodities, real estate and works of art, are every bit as subject to the whims of the emotional investor class as any other asset class.
Third lesson – Repeat after me: MLPs are not f***ing bonds. Bonds are bonds. A bad year in the bond market is like down 4%, not down 30%. High current income in any asset class is always a function of where risk is being priced. You don’t get 6-7% yields in a ZIRP world without a heightened chance for large principal loss. How many times must we learn and relearn this?
MLPs might be the Buy of the Century at today’s prices. And there is a case to be made that they are a functional and legitimate sleeve for a diversified portfolio. Just go in with eyes wide open and an ear for the kind of myth-making that ascribes supernatural qualities to an asset class that hasn’t lived up to them thus far.