Sectornomics: Energy

A man with an oil bottom bet made for income investors

Tim Mullaney, special to CNBC.com
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Amidst the worst crash in oil prices since the 1980s, with oil companies cutting capital spending budgets, Bayard Closser had an idea: Try to sell investors on a new fund focused on master limited partnerships in the energy business.

Does that make Closser crazy, or just crazy like a fox?

He's betting that the decline in oil dragged down companies that run infrastructure, like pipelines and storage terminals—solid companies with high dividends—right along with get-rich-quick companies betting on high prices to justify ever more speculative drilling.

The construction of the Gulf Coast Project pipeline in Atoka, Oklahoma. This 480-mile crude oil pipeline is being constructed by TransCanada and is part of the Keystone Pipeline Project.
Daniel Acker | Bloomberg | Getty Images

That idea turned into Vertical Capital's MLP & Energy Infrastructure Fund, a mutual fund that launched in December as oil cratered.

Irvine, California-based Vertical's partners weren't deterred by the oil crash. It even reminded Vertical Capital's team of a previous bottom bet—they spent 2008 buying up viable mortgages that were in the process of being battered by the financial crisis. They think they can do the same thing in oil now.

"It's not rocket science—it's basic value investing,'' said Closser, Vertical's president since 2010. The Vertical fund has $6 million in assets, according to Morningstar data.

To be sure, Vertical is not alone in bringing the MLP and energy infrastructure theme into a fund structure. Over the past several years, the MLP exchange-traded product space, in particular, has blossomed—there are now 23 exchange-traded products based on the theme, according to ETF.com.

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The biggest MLP funds
  1. Alerian MLP ETF: $9 billion
  2. JPMorgan Alerian MLP ETN: $5.5 billion
  3. ETRACS Alerian MLP Infrastructure ETN: $2.5 billion
  4. First Trust North American Energy Infrastructure ETF: $1.2 billion
  5. Barclays iPath S&P MLP ETN: $786 million
  6. Credit Suisse Cushing 30 MLP ETN: $746 million
    (Source: ETF.com, through March 1, includes exchange-traded notes)

By being "late to the game," Vertical thinks it's actually getting in at the right time. It's also getting into the space as an active manager in contrast to the index-based exchange products.

"We think that by having a smaller fund that's more nimble, we can move across big and small companies and add additional returns," Closser said. "Some of the bigger funds have to stick with the large-cap companies. But there are a lot of good small-to-midsize energy companies out there.''

He added that the idea is to concentrate on companies that are smaller than the giants, because many of them have been oversold in the last six months.

The strategy is flexible enough to make room for larger companies, and its three largest holdings are Williams Cos., Kinder Morgan and Plains GP, which have an average market valuation of more than $40 billion.

"There probably are opportunities in the sector, but you have to invest wisely,'' said Renaissance Capital analyst Nick Einhorn, who follows IPOs of energy partnerships. "Those are all well-known companies, so they are on the safe end. They're big and diversified and a good place to start.''

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You need some kind of adversity to allow the value to present itself. If you believe in the energy renaissance, the amount of infrastructure it will need will make this a good time.
Bayard Closser
Vertical Capital president

The idea is to avoid companies that drill and sell oil and to instead focus on service companies that help drillers move the stuff to market. That means mostly pipeline companies, said Scott Roulston, managing director at Cleveland-based MAI Capital Management, which acts as the subadvisor to Vertical's fund. The industry calls these companies "midstream players," sitting between the exploration companies at the "upstream" part of the business and the refiners and chemical companies, known as "downstream."

"We like the midstream because they're toll takers," Roulston said. "Their revenue is predictable and more visible. The industry's investment in midstream has been huge and will keep growing, even if not at the same pace.''

In other words, the midstream companies don't own oil, so they're not exposed to swings in the price of oil, Roulston said. And many details of their contracts with oil producers are publicly disclosed, making it possible for the fund to predict which MLPs will have the cash flow to increase their already-fat dividends in the future.

"There has been some disconnect in MLP fundamentals and the price declines they have experienced," said Peter Lazaroff, a financial advisor with Acropolis Investment Management who has expertise in MLPs. "Midstream MLPs have very little commodity exposure, and most of the major players haven't changed their distribution or distribution growth projections in response to the oil price decline," Lazaroff said.

He added, "Prior to the oil price declines and MLP selloff, the MLP space was looking a little frothy, so the pullback has made the asset class more attractive for new dollars." Lazaroff owns the JPMorgan Alerian MLP ETN as the best bet for broad asset allocation exposure to MLPs, and individual shares of Energy Transfer Equity, Spectra Energy Partners, and Magellan Midstream Partners.

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Best-performing MLP funds year-to-date
  1. Morgan Stanley Cushing MLP High Income ETN: 6.5 percent
  2. Global X Junior MLP: 5.5 percent
  3. Yorkville High Income MLP: 3.8 percent
  4. Direxion Zacks High Income MLP: 3.1 percent
  5. Global X MLP & Energy Infrastructure: 1.4 percent
  6. ETRACS Wells Fargo MLP ETN: 1.1 percent
    (Source: ETF.com, through March 1, includes exchange-traded notes)

The other big idea propelling the MLP bets is a focus on income: The current Vertical portfolio yields more than 6 percent annually, Roulston said. The Alerian MLP Index—the primary benchmark in the space—has a 6 percent yield, significantly higher than income offered from utility and REIT indexes.

The Vertical strategy is an offshoot of one MAI Capital began to pursue late in the last decade, after the financial crisis pushed interest rates to historic lows. MAI, which has a number of current and retired professional athletes as clients because it was once affiliated with the IMG sports-management firm, began looking for income investments other than bonds and settled on the master limited partnership business.

The Vertical fund has trailed the Standard & Poor's 500 stock index since its launch, but the middling start doesn't faze Closser, who said that if America is going to remain a top global oil producer, the market for companies that move the stuff is going to be robust.

The Alerian MLP Index, the primary benchmark in the MLP space, returned 4.8 percent on an annualized basis in the past year, through Dec. 31, and 12 percent over the past three years annualized. In the six months ended Dec. 31, the MLP index was down 10 percent. The Vertical MLP fund is up 1 percent in 2015, while the Alerian MLP ETF has declined close to 4 percent.

"You need some kind of adversity to allow the value to present itself," Closser said. "If you believe in the energy renaissance, the amount of infrastructure it will need will make this a good time.''

What you need to know about MLPs and MLP funds

MLPs' structure is based on a quirk of tax law that gives the partnerships an exemption from corporate taxation if they agree to pay out nearly all of their profits as dividends, on which owners of partnership units pay the tax. The combination of tax advantages and the growth of the domestic oil business since 2008 has put energy MLPs in the spotlight, with more than 50 initial public offerings of MLPs since 2012, according to Renaissance Capital.

But the situation changes in significant ways when an investor has assets in an MLP fund rather than an MLP single security holding. Here are six key factors to consider. Be forewarned: The following will make your head hurt if you aren't a tax lawyer. That's the point. These funds sound great on paper, throwing around terms like "energy renaissance" and "high income," but they are about as complex as retail investments can get in structure. And with high expense ratios—1.75 percent in the case of Vertical Capital's fund—investors need to educate themselves.

1. Structure is the most important decision in selecting an MLP fund, but each has its own set of trade-offs. There is no better fund vehicle for pure MLP exposure than an exchange-traded note (ETN), according to Peter Lazaroff, a financial advisor at Acropolis Investment Management, but investing in an ETN means the investor assumes the credit risk of a single financial institution, which is no small matter. Take the JPMorgan Alerian MLP ETN, the biggest MLP ETN. If JPMorgan were to go bankrupt, then the fund would go to zero regardless of any gains MLPs may have. (This risk exists with any ETN because they are structured as unsecured debt securities, even if their returns are based on equity benchmarks.)

2. Unlike MLPs, which allow partners to defer taxes, distributions in MLP funds are taxed as ordinary income. That means less complicated tax paperwork (no K-1) but makes holding an ETN or ETF in a tax-advantaged account more important, Lazaroff explained.

3. The reason why a fund like Vertical's is not 100 percent MLPs is because any fund holding more than 25 percent of assets in MLPs has to be designated as a C-Corp, which can hold 100 percent of assets in MLPs and retain the opportunity for tax-deferred income found in the underlying MLPs.

But C-Corps pay taxes at the fund level, which results in the C-Corp carrying a deferred tax liability—C-Corp investors don't pay taxes until they sell their ownership units. This has a huge impact on the fund's total return. Looking at the biggest C-Corp, the Alerian MLP ETF, the deferred tax liability has caused the fund to lag its index by eight percent per year since inception, Lazaroff noted.

Here's another way to look at it: If a C-Corp's holdings jumped by 10 percent in a day, the fund itself would pay corporate taxes (35 percent) on the gain, so the fund would only go up 6.5 percent. On the flip side, that can be beneficial in a down market. C-Corps should do worse in up markets and better in down markets, all else being equal.

4. Vertical's fund is organized as a registered investment company (RIC), allowing it to hold up to 25 percent in direct MLP exposure, and because they are not taxed at the corporate level, the income from 25 percent of the fund (assuming the manager takes full advantage of the ability to hold that proportion in MLPs) does enjoy the MLP tax benefits. But the distributions to the investor do not come in the tax-deferred form of individual MLP ownership.

5. The primary reasons investors should consider MLP exposure are the ability to earn tax-deferred income in a taxable account and the diversification benefit that comes from low correlation MLPs have to traditional asset classes, Lazaroff said. When you purchase indirect exposure to MLPs through a C-Corp or fund, these primary benefits are diluted or lost. That doesn't mean they are bad idea, but investors need to understand the trade-offs.

6. MLP funds offer high yields, but make no mistake, MLPs are an equity asset class, and should never substitute for a bond. "If you are in need of income and the majority of your assets are in a taxable account, then MLPs provide an interesting way to get some additional income in a tax-efficient manner," Lazaroff said. Unfortunately, getting the full benefits of MLP exposure requires direct purchases of individual MLPs.

—By Tim Mullaney, special to CNBC.com