Sometimes you have to pick the best-performing funds in a losing sector. While investors have no compulsion to invest, analysts get asked about picks all the time. Even when they may not be rather bullish about a sector, they are asked to pick based on “Well, what if you were bullish?” Don’t get us wrong. It is a useful exercise as it can position you for the moment you do get bullish. It can also be an exercise in finding a long-short paired trade. With that idea in mind we scoured the MLP sector.
This is a sector that inflicted maximum pain for investors. We have been rather hesitant to stick our necks out in the last year and aimed to stay with quality preferred shares. We have in general been avoiding the common shares. In some cases we have even recommended bonds. But there are now certainly some funds which offer good risk-adjusted plays for those that want to be long.
The First Trust Energy Income & Growth Fund (FEN) is one of the older funds in the sector and has the distinction of being relatively poorly followed. It invests in MLP shares but it has a broader mandate. It can invest in the Energy space outside MLPs and it has used that broader berth to dodge some of the body blows that have come to the pure MLP space. It also deploys options and that always is an area where we feel that the right funds can add a lot of alpha.
The Beat That Is Noteworthy
FEN has managed to beat ALPS Alerian MLP ETF (AMLP) over the last five years. While investors may roll their eyes and wonder why that is a big deal, we absolutely think that it is a noteworthy achievement.
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There are three reasons for our groupie behavior. The first being that FEN is leveraged and AMLP is not. Leveraged funds hurt more on the way down, so being able to outperform is fantastic. The second is that FEN obviously has a much higher expense ratio than AMLP, thanks to active management and the previously mentioned leverage. Finally, FEN has managed this outperformance while its shares have moved to a progressive discount to NAV. Five years back FEN traded at a minuscule 1% discount to NAV. Today that has blown out to 18.57%. This is a massive headwind to total return calculation and FEN still won against AMLP.
As of the September 30, 2020, update, FEN had a few unusual names in its top holdings.
Source: First Trust
TC PipeLines (TCP) and TC Energy Corp. (TRP) are rather unusual among MLP funds. The fund has also conspicuously avoided Energy Transfer LP (ET) in its top 10 holdings. We wrote about this one recently and it has no one else but itself to blame for its problems. ET is almost without exception a top 5 holding among MLP funds and avoiding this helped the fund outperform. FEN has also been a big believer in Utilities. Whether this was an intentional move to avoid the volatility of the MLP sector or the fund just got lucky, we cannot say. But the large position (about one third) in Utilities has made the fund look rather brilliant.
We Have Options!
FEN writes covered calls on its positions but it uses this so sparingly that we are not too thrilled. Total premiums received tend to average around 0.5% of fund assets on average and the fund uses them as a small yield boosting mechanism rather than primary volatility control mechanism.
FEN’s 11.1% distributions are average for the sector fund. FEN did cut its distributions recently and that was to be expected with the damage to the sector.
Source: First Trust
We believe the current payout is largely from dividends and distributions received by the fund and aided by the call options. FEN does not rely on capital appreciation to generate its current yield. FEN also trades at a large discount to NAV, so yield on market price is higher than yield on NAV. FEN enjoys the lowest danger level rating on our proprietary Kenny Loggins Scale.
A low danger rating implies a less than 15% probability of a dividend cut in the next 12 months.
FEN is a great way to play the MLP sector, but it would require a more bullish outlook than we have at present. One interesting fact here is that FEN and First Trust MLP & Energy Income Fund (FEI) have very similar portfolios and are managed by the same people. Since they have different fiscal year-ends we cannot confirm they have exactly the same portfolios at the exact same dates. But all our examinations over the past few years have suggested they are hard to tell apart.
Which one should you buy?
Well, there are two considerations here. The first is that if you want monthly income then FEI wins, as FEN is a quarterly payer. If that is not a consideration then on any given day, we would pick the one with the larger discount to NAV. Today this looks like a close call. But that has not always been the case.
A year back FEN traded at a 10% premium while FEI traded at a 10% discount. So there are moments when you can make an easy decision as well. For our portfolios though, we are sticking to preferred shares in the MLP space and generating more yield via safer cash secured puts and covered calls.
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Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.