ETF Edge - A second look at “preferred” stocks and MLPs 9/30/24

Episode Date: September 30, 2024

As active management and income-seeking come together more tightly, “preferred” stocks and energy MLPs are sitting at the nexus.           Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ. Let's rethink possibility. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you're in the right place. Every week, we're bringing you compelling interviews, thoughtful market analysis,

and breaking down what it all means for investors. I'm Pippa Stevens in for Bob Pizzani. Active management on the hunt for preferred stocks could lead to overlooked income opportunities. Here's my conversation with Jay Hatfield, founder and CIO at InfraCAP and Todd Rosenbluth, head of research at TMX VETIFI. Jay, I want to start with you here

because you run the Verdis InfraCAP, U.S. preferred stock ETF. It's up almost 20% for the year, leading its competitors. How does it work and what kind of companies are in it? Thanks, Pippa. It's great to be on. Well, it is important.

As you alluded to with fixed income to have active management. So what we do with PFFA is instead of cap weighting, which is what the big index fund does PFF. So we do ticker arbitrage. So we're PFF so it's active version and effect of PFF. So we select companies that we, by our own, ratings are mispriced relative to their risk and the yield. And then we also manage call risks of the securities trade above par. We sell those. We run modest leverage. We normally run 20 to 25 percent leverage. And so that's worked out well. We've had superior income and also superior total return. All right. So that's the strategy at the

highest level. What are the top holdings in the fund itself? Most of the top holdings are in what we call asset-intensive businesses. So companies, like a lot of viewers probably know, energy transfer is a gigantic pipeline company. The rating agencies don't like pipeline companies because they pay dividends. And so we like those asset-intensive businesses. And in the case of energy transfer,

the company as a whole is rated investment grade. But the rating agencies also don't like preferreds. they give them three notches, it's called, with ratings. So the preferred's rated double B, which is not investment grade, but the bonds are investment grade. So we like that situation where you get substantial yield, but really de minimis, or not de minimis, but small default risk. All right.

So Todd, I want to bring you in here because Jay's PFFA has seen about $500 million in inflows this year. How does that compare to other preferred stock funds? Well, most of the preferred assets are an index-based products. So we've seen products from iShareers, from State Street. There are some of the other larger asset managers that offer preferred ETFs. But I would broaden this out a little bit. We are seeing growing demand for active fixed income ETFs.

They've been punching above their weight in 2024. We've seen firms like Capital Group and Tiro Price, Fidelity, have a lot of success. BlackRock brought one of its best known PMs into the active ETF world about a year ago when it's had a lot of success with the Black Rock flexible income ETF. So we are seeing some of the larger asset managers focus on active income strategies and have a lot of success. All right. So Jay, broadening things out here. You have a 6,000 forecast on the S&P, noting the risk to your target is mostly to the upside. So how much of that price target hinges on the Fed's rate cut path from here? Well, it's obviously critical. I mean, that's really one reason that fixed income, particularly

higher risk fixed income, so high-yield bonds and preferred stocks, they tend to do better than other fixed income categories when the stock market is strong and when we're coming out of a tightening cycle like we are now. So it really is critical. Although we don't think there's a lot of risk to the Fed's rate path, because if you really adjust the PCE and CPI data for shelter, which the Fed is starting to do, thank God, finally, so you really get inflation levels that are below two. So there's really no reason for them not to cut,

and the rest of the world's cutting, and the rest of the world needs to cut because they actually are nearly in a recession. So we don't think there's a lot of risk to that, but clearly if they stopped cutting, that wouldn't be, preferred to be okay, but they wouldn't continue to rally like to happen. All right. So looking at the rest of the world as well. And Todd, we just saw the industry pass the $10 trillion milestone

and many billions of inflows of that going into other actively managed funds like Jay's, as you noted. But you point out that active ETFs have gathered approximately 30% share of the industry's flows. But stats show that supply at this point is now exceeding demand. And given the ETF industry, has a history of being a little overzealous maybe when it comes to trends. You know, is it different here? Well, I think there's notable demand.

As you talked about, 30% of the overall flows have gone into actively managed GTFs. We've seen product development on the active side this year through covered call strategies, some of those options overlay, active fixed income, active equity strategies. This is what advisors and, and investors are increasingly turning to. And it's very hard for an asset manager to bring to market a product that's gonna compete with the Vanguard 500 ETF, VOO that charges three basis points

and has gathered about $80 billion of net new money this year. So asset managers are bringing products to market that we believe investors want and it comes down to education. And we've seen a number of success stories in the past year. So the Tiro price, capital appreciation, Equity, ETF, TCAF, is one of those success stories that we've seen that the fund has come out and gathered notable assets in the past year. And Tero Price obviously leveraging its expertise in the active management space.

And sticking with that, Todd, ETF AUM typically takes about five years to double, but this time it was less than four years. You know, do you see that pace continuing? And do you think that they'll continue to take share from mutual funds? Without a doubt, active ETFs and ETFs in general are going to continue to take share from mutual funds. This pendulum is not swinging back for seeing investor demand for ETFs, whether that's institutions that are getting more comfortable using ETFs and products that are tied to the CLO marketplace are a great example. You've seen Bitcoin products have success in 2024. That's a different investor base that is now moved into ETFs. Retail investors are gravitating and becoming more comfortable in using ETS.

ETS are here to stay, and we're seeing more and more traditional asset managers file and launch products because this is where the investor base happens to be. All right, so Jay, I want to switch gears here a bit because your next largest fund by AUM just under $400 million is your MLP ETF, ticker AMZA. Now, something interesting going on here is that MLPs are associated, with oil and oil is closing out its third monthly loss in a row. But you say MLPs are now only 20% correlated with oil prices. Can you explain that a little bit? Yeah, so fortunately, because it was pretty stressful running that fund over the last 10 years, that's one of the first actively

managed funds that had launched. But unfortunately, we launched it at a very terrible time for MLPs. But what's happened is that the companies have de-levered, have much higher coverage of dividends, and also probably most importantly, to respond to your question, have a big leverage to natural gas. The export of natural gas is extraordinarily compelling. In the U.S. natural gas trades for about the equivalent oil equivalent of $12 a barrel on a BTU. basis, whereas it trades pretty close to oil, which is obviously in the low 70s. So that arbitrage is so enormous. It's driving flows down to the Gulf and exports.

And some MLPs like Schneer actually operate the export terminals. So that growth story has sort of overwhelmed the fact that, you know, oil and refined products, you know, aren't people aren't as bullish about and really started to drive performance. Plus, retail investors got way too negative about MLPs, particularly after the pandemic. So they've been absolutely crushing it for the last, well, really, since the pandemic. And Jay, one of the big themes in the energy space this year has been an M&A activity. We've seen a lot of that concentrated in the upstream. We have seen some of the pipeline companies consolidate.

But given how difficult it is to build new infrastructure, particularly from state to state, is that as, you know, consolidation looking ahead, is that that, a catalyst at all for the industry? Absolutely, and it's a good demonstration of what I was asserting, which is MLPs are mostly driven by retail investors who want to get tax deferred income because you get tax shelter from the depreciation that gets passed through in the partnership return. And so because it was so retail focused and they got kind of burned and didn't fully understand it, got way too cheap.

So major corporations have been buying up MLPs. And they've really created a shortage of opportunities. And I know, so if you look at like AMLPs, one of our competitors, when something is bought out, like they have to buy all the other constituents that are all MLPs and it drives their price higher. So there's a developing shortage of MLP equity. But investors who own them want more of them because it's one of the few ways you can get fully taxed deferred income most of the time. And sticking with that, Todd, AMZA is in the middle of the

pack this year in terms of performance and its larger competitor. The Illyrian MLP fund is at the back of the pack. So is size a factor here? Is it any type of hindrance? I don't think that's the case. So again, for full disclosure, I work for the company that is the index provider behind the Illyrian MLPETF. I want to broaden this out into why MLPs make sense. Energy is the worst performing sector, I believe in the S&P 500. MLPs are not part of the S&P 500, so you can get great exposure to large-cap companies that are high-quality, free cash flow, dividend-paying companies through ETFs like AMLP and some of its peers. So this is a great strategy, great to add to your overall broadly diversified portfolio, and you likely don't have any exposure to MLPs if you own just

a core S&P 500 index-based strategy. All right, and Jay, you said that you think looking ahead value could outperform growth. What about small caps? Because they've outperformed in Q3. Does that trade have more room to run looking ahead? We think they do. And the one thing that's never really discussed publicly is that a lot of the reason they'll outperform is not because they borrowed too much and have too much floating rate.

It's just a sector. It's not only that that. It is partly that. But the sector allocation in the small cap index is much less tech focused. It does have a lot of financials, a lot of reeds, which will do well when rates drop. So a lot of strategists go on your channel and say, oh, well, they don't like small caps because the economy is going to be weak or something like that. But what you're really saying then is you don't like financials.

You don't like rates. You don't like some of these beaten down stocks. because that's really the primary driver of that return. They are also cheaper than their large-cap components in the same sector. So you're getting kind of a double discount, and getting the value stocks, but even cheaper than the large-cap value stocks. All right.

And finally, Key Ford kicks off tomorrow. So got to ask, you know, the top trends to watch. Todd, what is on your radar as we enter Q4? Well, we could have a record year for ETF. flows. We are on pace to cross the $900 billion net inflows, given where we are thus far. Just above that was the record a couple of years ago. So we're excited. The ETF industry continues to gain ground. We already have a record for fixed income flows with three months to go. We'll see if we can get there from an overall asset category standpoint. It's a great time to be following the

ETF industry. All right, record year for ETF flows. And Jay, what about you? What are you watching as Q4 gets underway? We would definitely focus on the financials. We think the rally in financials is going to broaden out. So we've been bullish on some of the big investment banks like Goldman Sachs and a little bit cautious about the regional banks. But now the regional banks are turning the corner on net interest margin. So we would look to that sector to see if we're correct about these riskier more cyclical companies like financials and REITs, doing better than the more conservative of staples and drugs and utilities. That does it for ETF Edge, the podcast.

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