ETF Expert Corner

Jay Hatfield on MLPs, InfraCap MLP ETF

November 29th, 2016 by ETF Store Staff

Jay Hatfield, Co-Founder & President of Infrastructure Capital Advisors, explains the basics of energy-focused master limited partnerships (MLPs) and spotlights the InfraCap MLP ETF (AMZA).



Transcript

You can listen to our interview with Jay Hatfield by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're spotlighting this week is the InfraCap MLP ETF. The ticker symbol on that is AMZA. Joining us via phone from New York to discuss this ETF is Jay Hatfield, Co-founder & President of Infrastructure Capital Advisors. He's also Portfolio Manager for this ETF. Jay, our pleasure to have you on the program today.

Jay Hatfield: Thank you for having me, I appreciate it.

Nate Geraci: Jay, first of all, can you explain for our listeners what MLPs are and how they're typically used?

Jay Hatfield: Yes, MLPs were created by special tax legislation in the 1980s and what that legislation did was allowed energy companies mostly to be publicly traded partnerships. There's a ban on publicly traded partnerships other than energy companies, and so that created this asset class and it's grown steadily since the late '80s to the point now where there's over 500 billion of MLP equity outstanding.

Nate Geraci: I know one of the keys here is that MLP unit holders receive distributions. MLPs must pass through 90% of their income. Can you talk a little bit about that?

Jay Hatfield: The MLPs are publicly traded partnerships so you get something called a K1 if you hold them directly, and that's a partnership return, and what you'll get typically from an energy MLP is you'll get a lot of depreciation passed through to your tax return which offsets the cash, so there's usually not a lot of current taxes paid with master limited partnerships, so investors find that attractive. It does add to complexity if you hold them directly in your portfolio and just buy individual MLPs, and so that's an advantage of delegating to ETFs or Closed-end Funds or other structures where you don't have to file the K1s.

Nate Geraci: Jay, you mention many of these MLPs are found in the energy space. Can you explain what's the basic business model for oil and natural gas MLPs?

Jay Hatfield: The key distinction, and this is a big recommendation that we always give from our firm, is that the asset class that we participate in is what we call midstream MLPs, so they're the companies that own the pipelines and storage that moves natural gas and crude oil and liquids from the well head to actual distribution to retail investors. Those are long term assets. They're utility-like. In some cases they're regulated by the Federal Energy Regulatory Commission, FERC, so they also have rights of way and long term value. There are other segments that we don't participate in, we recommend investors be cautious about. There are some upstream MLPs that deal just with drilling for oil, and there's other MLPs that got grandfathered into the asset class that we view as being too risky. There's also refining MLPs and shipping MLPs and those don't, in our opinion, have the long term franchise value that a pipeline or storage company has, so it's important to make that distinction and look for ... We view the asset class as a long term investment that produces income in a portfolio, so we prefer to participate in those more conservative, more long lived assets that are stable over long periods of time.

Nate Geraci: The ETF we're spotlighting today is the InfraCap MLP ETF. Again, ticker symbol AMZA, and you just started walking down the path as to your views on the MLP space, but walk us through in more detail what this ETF holds and what the end investment goal is.

Jay Hatfield: The most important thing is that we do track an index called the Alerian Infrastructure Index. There's only 25 companies ... They're the largest, most liquid, mostly investment grade rated companies that participate in just this midstream segment, so no upstream, no shipping, no low quality assets. We track that index and then we try to optimize the returns of that index with three strategies. First of all, we have our own weightings, so based on the relative attractiveness of the companies, we'll be under or overweight each of those 25 companies. We also write covered calls on the companies to generate extra income, and finally we'll run a modest amount of leverage, usually between 20 and 25% leverage, to enhance the yield of the asset class over time.

Nate Geraci: Jay, if you look at the yield on this right now, give us an idea as to where that's currently at.

Jay Hatfield: The way I like to think about it is that cash yields right now is 9.6%, and then we are distributing ... We also have a target of generating another 8.4% from option proceeds, so the total yield would be 18%, but I prefer to have investors think about the 9.6% as the cash coming into the portfolio, and that compares with the index which is yielding right around seven, so we have a higher cash yield because of the leverage and then we have weightings towards what we view right now as some of the depressed companies that have higher yields in the index.

Nate Geraci: Again, we're visiting with Jay Hatfield, Co-founder & President of Infrastructure Capital Advisors. We're spotlighting the InfraCap MLP ETF. Jay, this ETF is actively managed. Why do you think that's important in the MLP space?

Jay Hatfield: I think that particularly in times, there's been a dislocation because of low quality companies I've mentioned. A lot of them cut their distribution or even filed for bankruptcy, so there was a dislocation even with these larger cap, stable companies, and because of that dislocation, the actual index really didn't reflect some of the better opportunities, and in fact in one unusual situation, a company went way down in price, kicked out of the index at below 10 dollars and then added back to the index around 18 dollars just because of mechanical rules, so the volatility really created a lot of opportunity relative to weightings, and then we believe that over long periods of time, writing covered calls and running leverage is an easy way to add extra value if it's done intelligently and actively, so we think that that's an attractive structure for investors relative to just holding the passive index.

Nate Geraci: Outside of the active management, just generally speaking, how does this ETF compare to some of the other MLP ETFs on the market? Because I know there can be some pretty significant differences in the way MLP ETFs are taxed and how holdings are weighted, so what do you see as some of the primary differences here?

Jay Hatfield: The key difference is that we are taxed as a corporation, and so we file a corporate tax return, so investors get just a 1099, which is the same return they'd get from any stock like IBM or any other stock that pays dividends, so that simplifies the tax reporting. We do accrue for taxes, so there are other ETFs that are structured as notes, and there's no tax deferral with those notes, with those other structures, so everything you get is 100% taxable. Most of the time when we distribute cash it'll be return of capital and so tax deferred, so it's important to look at those different structures so you understand how it's going to be taxed and what type of accounts you should put it in.

Nate Geraci: What about the weighting of the underlying holdings? How does that compare to some of the other MLP products that are in the market?

Jay Hatfield: I've mentioned, a number that are just purely the index, so they'll just hold mostly a cap weighted portfolio and what we do is we have our own valuation models and we look for the most attractively valued companies, and we can also have the flexibility to add companies that aren't just LPs. There might be the general partner which has a potential higher return than the GPs. For instance right now we're holding ETE which is the parent of ETP or Energy Transfer Partners, and there's just a merger announced between Energy Transfer Partners and Sunoco. Sunoco and Energy Transfer Partners didn't perform that well, but ETE has performed extremely well because they're going to benefit from that merger, so it gives us more flexibility to have the same risk from the underlying assets, but just hold it with the superior structure.

Nate Geraci: Year to date, this ETF has returned about 21%, but it was down substantially last year. I'm curious, how closely are the fortunes of MLPs tied to the actual prices of oil and natural gas?

Jay Hatfield: It's an interesting dichotomy. Again, because of those lower quality companies, last year the high quality MLPs became extremely correlated with energy. In fact even they became more volatile than even the drillers, but the underlying cash flows are only about 10 or 20% correlated, so if there is a dip in oil and MLPs go down, we view it as a long term buying opportunity, but investors need to be aware of the fact that if they're looking for price appreciation, probably going to need to be in an environment where oil prices are increasing. We believe ... We do macro research. We do believe that it's a good environment for oil prices. We think that prices are going to be higher in 2017 as the high cost production that the offshore globally starts to run down over time, so we're bullish about that, but I think it's important for investors to recognize that is a risk factor or volatility factor that you're adding to your portfolio when you participate in the asset class.

Nate Geraci: Again, we're visiting with Jay Hatfield, Co-founder & President of Infrastructure Capital Advisors. We're spotlighting the InfraCap MLP ETF, ticket symbol AMZA. So, Jay, in a nutshell, where does this ETF fit in an investor's portfolio? I know when many investors think about MLPs, they think income. Is that the primary goal here?

Jay Hatfield: That is, and I think it's important to make two distinctions. First of all, it's equity income, so this is not going to act like a bond. That's both good news and bad news, so most recently with treasuries backing up substantially, bond-like investments, clearly investment grade bonds, but also utilities and REITs have significantly under-performed whereas MLPs, particularly now with their yield being high, are not significantly sensitive to interest rates but just really more beta or the stock market and oil prices, so we would put it in the equity income category. So people need to recognize, investors need to recognize that this is not something that's going to go up when the market goes down, but it is something that produces income and total return. These companies typically grow their distributions about 5% a year, so it's a very attractive long-term income vehicle, but it's not meant to, as I mentioned, reduce the overall volatility of your portfolio like something like the Vanguard Total Return or some investment grade bond-like product might perform in a portfolio.

Nate Geraci: Jay, you mention REITs and utilities. Obviously over the past several years we know a number of investors have turned to higher yielding areas of the market in search of income just given how low interest rates have been and certainly MLPs have been one of those areas. High level ... How do you suggest investors think about risk and reward when it comes to seeking income in their portfolios, whether through MLPs or other higher yielding investments? What's the right balance there?

Jay Hatfield: We think that investors generally don't put enough income securities into their portfolio and the advantage of having income is that either if you need it for your current expenses or if you're retired, you don't have to sell securities, and that's a tremendous advantage, or you don't have to sell as many securities if you have substantial income, so then you don't have to end up selling at the bottom, so we think that having a diversified portfolio of income securities is a very attractive way of investing and only having bonds, though, is not necessarily the best structure. My mother-in-law called me yesterday and asked why her portfolio so volatile, and really the reason it's volatile is she had all the low risk treasury-like investments, but if you have some utilities, some REITs, some MLPs, like three to five to 10% allocation of all those asset classes, they produce long term income but because they have different risk factors, they, as a portfolio, don't have as much volatility, so like I mentioned, utilities and REITs have been doing poorly. MLPs have been doing well recently, but last year, REITs and utilities were doing well and MLPs were down, so if you have a portfolio with securities ... Be a higher income but not necessarily have huge volatility associated with it.

Nate Geraci: All right Jay, let's talk a little bit about the environment for MLPs moving forward, and now that we know Donald Trump will be the next President of the United States, there's been a lot of talk about infrastructure spending and of course less regulation in the energy space. Are these things that could potentially benefit the MLP space?

Jay Hatfield: Well, there's going to be probably a very, very near term benefit. For instance, Energy Transfer Partners and Sunoco are building ... They have it half-built, a pipeline out of the Bakken Shale through the Dakotas, and right now that's being held up by some protests and the Obama Administration because they won't give the final permit, so in all likelihood, we don't know this for sure, but we're guessing that when Trump becomes President, he's going to allow that project to go through, but more importantly, broadly, there has been a policy to stop almost all oil and gas development or at least limit it as much as possible as the President could, and under Trump that's clearly not going to be the case. In fact, it's really going to be the reverse, where there's going to be some effort to stimulate that, and more importantly, the U.S. is the lowest cost producer in the world for incremental oil production, so as long as the administration's not actively trying to inhibit that growth, that we expect U.S. production to grow steadily over the next five years and even have the U.S. be energy independent. That's going to be positive not just for the drillers but also for these infrastructure companies, the midstream infrastructure companies, that are providing the pipelines and the processing and the storage relative to that. We do think it's a big positive and we think the environment is positive for these infrastructure companies.

Jason Lank: Jay, this is Jason Lank. You mentioned a reference to the Dakota Access Pipeline and the mess that's going on up there with protesters and water cannons and so forth. A question, how hard is it to build a pipeline today given capital constraints, environmental concerns, land requirements ... Is it almost an undoable task?

Jay Hatfield: Through certain areas it's difficult. Through the northeast, certainly. There's a pipeline being held up in New York because of a technical issue with an environmental permit, but in most of the country, and particularly Texas and the central part of the country, it's not that difficult to get the environmental permits, to get the land, to get the rights of way, and despite some elements of the Obama Administration, the FERC and other federal agencies are really set up to facilitate that, so it's more doable than you would think, and we think that given the change in administration, that now those projects will go forward, so we think that part of it is doable. It's not the easiest thing in the world, but these companies are experts at getting these approvals, and then the capital markets are open for these companies. They're very attractive long-term projects and investors are open to funding that, and even during February when the worst parts of the depression in the energy business, private equity investors were investing in these companies, so because of the long-term nature of the assets and the stability, there's almost always capital available for them to access.

Nate Geraci: Jay, we're about out of time so we will have to leave it there. Excellent perspective on MLPs today. Certainly an interesting ETF and AMZA. We appreciate you joining us today. Thank you.

Jay Hatfield: Thank you very much for having me.

Nate Geraci: That was Jay Hatfield, Co-founder & President of Infrastructure Capital Advisors. Again, the ETF is the InfraCap MLP ETF, and you can learn more about this ETF by visiting InfraCapMLP.com.