Pair trading MLPs

October 23, 2015 01:00 PM

Profit taking among healthcare funds wasn’t a surprise as global equity markets shuddered in August, but one remarkable development was positive flows into the downtrodden energy sector.

And with the only significant outflows coming from those Master Limited Partnership (MLP) funds that had been spared the worst of the trauma affecting the sector over the last year. Maybe what’s most surprising is that investors didn’t shy away from MLP funds before now, but one investor’s misfortune is another’s gain and a great opportunity has opened up for income starved (and nimble) investors.  

MLP funds were once one of the fastest growing segments of the energy market as they were sold as the cure for whatever ailed your portfolio. Need current income without sacrificing upside potential? What about a strong up-capture ratio with low correlations to the broader market? MLP funds were one answer and investors grabbed them up with both hands. The first MLP ETF, the ALPS Alerian MLP (AMLP), took in over $5 billion in assets in just 2012 and 2013 plus another $1.6 billion in 2014 and even during the worst of the rout in energy stocks, fund flows remained positive quarter over quarter. It was only in the third quarter of 2014 (see “Keep it coming”) that investors began to turn away from the sector as concerns over dividend sustainability began to grow with the bulk of the outflows hitting either relatively low yielding funds like First Trust North American Energy Infrastructure Fund (EMLP) or smaller and higher yielding funds that had seen declining payouts such as the Yorkville High Income MLP (YMLP).  

The recent underperformance of MLP’s relative to the broader energy sector has opened up new opportunities for income hungry investors. First, we have to acknowledge that the largest MLP funds that concentrate in the more stable midstream segment have yet to trim dividends. In fact, AMLP has only seen its year-over-year dividend growth slow slightly in the last three quarters while the sell-off in late August brought its trailing 12-month (TTM) dividend yield up to 8.5%. And with oil prices bottoming out close to the lows of 2009, the market could be at a turning point offering strong price appreciation. But with an 8.5% yield that is more than 600 basis points above the 10-year Treasury yield as of late August, using a pair trade to remove the market risk and lock in that spread could be very profitable. Currently there is only one unlevered inverse broad energy fund, the ProShares Short Oil & Gas ETF (DDG), available to investors but going long both funds in the right mix could potentially produce a steady income stream without taking on the equity beta. 

No pair trade is without risk; first is finding the right fund for the inverse position followed by the need to stay on top of the mix between the two. Beta, like duration, shifts over time and while traders should have no issues with staying on top of fluctuations, a pair trade might prove difficult for retail clients to manage. The bigger risk is that while traders might be able to lock-in an attractive yield, they could be missing out on greater upside potential from simply being long a very downtrodden sector. While the energy sector continues to trade a TTM P/E multiple of 14.5x in late August that may appear unattractive. According to GuruFocus.com, on a 10-year annualized basis (Shiller P/E) the sector is much more attractively priced at 11.2X compared to the S&P 500 at 25.2X, and may soon attract more value-hungry investors looking to profit from a multi-decade low point for the industry.

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global