ETFs and Behavioral Finance

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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%.

 

AMLP’s Tax Bondage

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Tax Freedom Day is that point in the year when you’ve figuratively earned enough to pay all your taxes. For the rest of the year you can feel as if your income is your own. Naturally, it can never come soon enough. Investors in the hopelessly tax-burdened ETF, the Alerian MLP Fund (AMLP) face the contrary prospect: the point at which their investment returns are taxed at the fund level before anything is paid out. If the opposite of freedom is bondage. AMLP investors recently passed Tax Bondage Day.

This comes about because AMLP is not a conventional ETF, but is a tax-paying C-corp. Anecdotally, it’s clear few investors realize this, because most ETF’s are RIC-compliant and therefore not taxable at the fund level. Conventionally, you don’t stop to consider whether the ETF you own is taxed like a corporation. But AMLP is a C-corp, paying taxes on its earnings before paying out what’s left to holders.

The weakness in energy infrastructure last year wiped out unrealized gains for AMLP and many other tax-burdened MLP funds. Since you don’t owe taxes on losses, AMLP’s Deferred Tax Liability (DTL) was eliminated. However, the sector has been recovering since late November, and probably the only negative consequence of the rebound is that AMLP now has unrealized gains once more. Therefore, it has begun to owe corporate taxes again. As of January 16th it owed $93MM, a cost in addition to and approximately equal to their annual management fee. As the market rises, so will their DTL.

You can find further detail on this issue from past blogs. Hedging MLPs explained how AMLP is useful as short position, because the tax drag will limit its appreciation to 79% of the market’s whereas it can still fall 100% of the market. Some MLP Investors Get Taxed Twice and Are You in the Wrong MLP Fund both examine the implications of a tax-paying C-corp for investors.

The reduced corporate tax rate means the tax drag is less than it used to be – and it’s been substantial. Since inception, AMLP has returned less than half its benchmark, largely because of tax expense. The reduced corporate tax rate will help, but it’ll still represent a serious drag on returns. Many investors are expecting strong performance over the next couple of years. Valuations are attractive, and energy lagged the market substantially in 2017. Seeing your fund hand over 21% of a double digit return before paying distributions will represent a substantial cost, and an unnecessary one because there are correctly structured energy infrastructure ETFs around that aren’t subject to corporate tax. It is possible to invest in the sector via a RIC-compliant vehicle.

On a different topic, the U.S. Energy Information Administration confirmed its forecast of record hydrocarbon production in 2018. Natural gas and natural gas liquids broke records in prior years, but this year crude oil production will also breach a previous high. Moreover, the mix of hydrocarbons should please almost everybody because it’s moving heavily away from coal and towards cleaner-burning natural gas. America’s emissions are moving in a better direction, thanks to the Shale Revolution.

The investable American Energy Independence Index (AEITR) finished the week -1.5%. Since the November 29th low in the sector, the AEITR has rebounded 12.8%.

We are short AMLP

Rising Rates and MLPs: Not What You Think

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Five years ago my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors argued that interest rates were likely to stay lower for longer. Excessive debt led to the 2008 Financial Crisis, and our thinking was that low rates were part of the necessary healing process, allowing the burden of debt to be managed down.

Rates have indeed remained low, helped by the Federal Reserve’s very measured steps to “normalize” the Federal Funds rate with periodic hikes. Most forecasters, including the rate-setting members of the Federal Open Market Committee, have consistently expected rates to rise faster than they have.

Nonetheless, ten year treasury yields have been drifting up and recently touched 2.6%. Unemployment remains very low if not yet inflationary. GDP growth and corporate profits are strong. The recent tax changes are fiscally stimulative. Bill Gross has declared that we’re in a bond bear market, and Jeffrey Gundlach sounds equally cautious. It’s likely that this will be an increasing topic of conversation among investors.

We have no view on the near-term direction of bond yields, beyond noting that current yields are too paltry to justify an investment. It’s been a long time since bonds looked attractive. As we noted in our 2017 Year-end Review and Outlook, interest rates are what make stocks attractive. The Equity Risk Premium (S&P500 earnings yield minus the yield on ten year treasury notes) favors stocks, but if rates rose 2% bonds would offer meaningful competition. Although a 4-4.5% ten year treasury yield is a long way off, the historic real return (i.e. yield minus inflation) going back to 1928 is 1.9%.  So 2% above an inflation rate of 2% that’s rising wouldn’t be historically out of line.

Energy infrastructure investors will begin considering how rising rates might affect the sector. Traditionally, MLPs were categorized as an income-generating asset class along with REITs and Utilities. Rising bond yields have in the past represented a headwind for all these sectors, although MLP cashflows are not that sensitive to rate movements. Debt is predominantly fixed rate, and certain elements of the business, such as pipelines that cross state lines, operate under highly regulated tariffs which include annual inflation-linked increases.

Fairweather Friends

But energy infrastructure has undergone substantial changes over the past three years. Although yields are historically attractive, the volatility of 2015-16 was inconsistent with the stable, income-generating asset class investors had sought. As we’ve noted before (see The Changing MLP Investor), the Shale Revolution created growth opportunities that upset the business model and led many MLPs to “simplify,” their structure, which in practice meant they cut distributions in order to finance new investments. Consequently, the path of U.S. hydrocarbon production growth is more important than in the past.

The long term relationship between MLPs and treasury yields is not a stable one. The correlation between rate changes and MLP returns has fluctuated over the years, reflecting that there’s a weak economic connection between the two. Initial moves up in rates have often led to short term weakness in energy infrastructure, probably due to competing fund flows as noted above with REITs and Utilities. However, recent bond market weakness has led to the opposite result. The correlation is becoming negative.

This is likely because the strengthening economy, which is driving up rates, is improving the outlook for the energy sector as well. Energy infrastructure is more sensitive to volume growth, since this increases capacity utilization of existing facilities as well as the likelihood of further growth. A stronger economy will, at the margin, consume more energy. The 12 month rolling correlation (through December 2017) is the most negative it’s been since the sector peaked in August 2014. In January this relationship has persisted, with rates and MLPs both moving higher. So far, the economic forces that are causing weaker bond prices have been positive for energy infrastructure.

The investable American Energy Independence Index (AEITR) finished the week +1.9%. Since the November 29th low in the sector, the AEITR has rebounded 13.9%.

 

An Expensive, Greenish Energy Strategy

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Most of the U.S. has been unseasonably cold – enduring twelve consecutive days of sub-freezing highs in New Jersey while owning a home in SW Florida is your blogger’s self-inflicted wound. The pain is only slightly ameliorated by news of record natural gas consumption of over 140 Billion Cubic Feet (BCF), almost twice the annual daily average.

You’d think that would be enough to satisfy demand, but the extended cold weather has exposed gaps in New England’s energy strategy. The region’s desire to increase its use of natural gas for electricity production is not matched by enthusiasm for infrastructure to get it there. Consequently, prices reached $35 per Thousand Cubic Feet (MCF) recently, roughly ten times the benchmark. Even at that price sufficient quantities weren’t available where needed, with the consequence that burning oil was the biggest source of electricity generation during this period.

In many cases, environmentalists’ views on natural gas are self-defeating. As a replacement for coal it surely reduces harmful emissions, and the widespread switching of coal-burning power plants for gas-burning ones represents a great success for environmentalists — for all of us. U.S. electricity generation is cleaner than in Germany (see It’s Not Easy Being Green). The New England Independent System Operator (ISO) has increased natural gas usage from 15% of electricity generation in 2000 to where it’s the most used fuel (other than very recently).  They correctly note that natural gas supports increased use of renewables, since wind and solar power are intermittent.

It should be a good story, except that the ISO’s increasing reliance on natural gas is opposed by environmentalists blocking the necessary additional infrastructure. In the last couple of years Kinder Morgan (KMI) and Enbridge (ENB) both cancelled projects that would have improved natural gas distribution and storage in the region. This was because of adverse court rulings, and regulations that dis-incentivize utility customers from making the necessary long term purchase commitments, without which infrastructure doesn’t get built.

As well as enduring the highest natural gas prices in the country, Massachusetts also imports Liquified Natural Gas (LNG). New England relies on LNG for 20-40% of its natural gas needs during winter. The Jones Act is a Federal law which requires intra-U.S. shipping to be carried out on U.S. owned, built and crewed ships. It’s expensive, and although this point is not the fault of Massachusetts, it means they’re importing LNG from Trinidad, even though the U.S. exports some of the cheapest LNG in the world. There’s little natural gas storage in the region, because the geology doesn’t support underground storage and opponents have prevented construction of above-ground facilities. Consequently, LNG is imported to Boston when needed in the winter, as long as a winter storm doesn’t disrupt shipping.

The high prices for natural gas in New England aren’t the only problem though. The recent jump in oil use for electricity generation is hardly consistent with lowering emissions. Meanwhile, New England’s ISO is warning that infrastructure development is inadequate, which risks the reliability of the electricity supply and in extreme cases may result in “controlled power outages”. The U.S. Bureau of Labor Statistics reported that in November 2017 the Boston area paid 57% more for electricity than the U.S. average, compared with only 28% more five years ago. It’s not just a winter problem. For 2017 (through November) Boston prices were 175% of the national average. New England is a wonderful region of the U.S., but its residents are poorly served by a dysfunctional energy strategy.

On a different topic, global auto sales exceeded 90 million units for the first time last year. China was 25% of the total. 2018 is likely to be another record. This is why the International Energy Agency is forecasting a 1.3% increase in crude oil demand this year.

The investable American Energy Independence Index (AEITR) finished the week +2.7%. Since the November 29th low in the sector, the AEITR has rebounded 12.4%. For most of 2017 the strength in Utilities contrasted with energy infrastructure weakness. However, this relationship has sharply reversed, with the Utilities Sector SPDR ETF (XLU) falling 9.3% since the late November low in AEITR. In mid-November we highlighted the poor relative valuation of the Utility sector (see Why the Shale Revolution Hasn’t Yet Helped MLPs). As the Administration announced plans to open up most of the offshore U.S. for oil and gas exploration, Interior Secretary Ryan Zinke declared, “We’re going to become the strongest energy superpower.”

We are invested in ENB, LNG and KMI.

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