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5 Reasons To Consider Buying AMZA

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http://www.infracapmlp.com/about/management.html - AMZA is the first actively-managed C-corporation MLP ETF and was issued in October 2014.

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5 Reasons To Consider Buying AMZA

  1. 1. 5 Reasons To Consider Buying AMZA  AMZA is the first actively-managed C-corporation MLP ETF and was issued in October 2014.  The fund made its first distribution in January 2015, and at $0.50 would project to amount to a roughly 9% annual yield.  I provide five reasons to consider buying this fund, ultimately relying on the skill of the fund's manager. Last October, I wrote about C-corporation Master-Limited Partnership (MLP) ETFs, and mentioned a couple of ETFs that, due to their recent inception, had insufficient background to enable adequate discussion. I would like to backtrack a bit to discuss one of those "young" funds: InfraCap MLP ETF (NYSEARCA:AMZA).
  2. 2. AMZA began trading on 2 October, 2014; its start could not have been less propitious. The fund's holdings are all in the oil industry, and in October, the industry was in the midst of a major decline in oil prices. The drop in oil prices has dampened investor expectations. AMZA is a C-corporation ETF focusing on MLPs; it is also one of the approximately 125 actively-managed ETFs currently available. Both of these considerations mean that AMZA is going to have a substantial expense burden: C-corporations must pay taxes on their income,2 and actively-managed funds generally cost more to operate.3 The question that confronts the potential investor is whether an actively-managed fund - and a tax-burdened one, at that - is worth the additional expenses. Given that the active ETF is going to have to pay out more than the passive ETF, and given that those expenses are ultimately taken out of the moneys that would normally go to shareholders in the form of distributions, is the active fund going to pay out better than a passive fund? While it is up to the individual investor to decide the issue of what counts as "better," and while each active ETF is different, I have five considerations that apply to AMZA that may make it an attractive holding. My research in, and understanding of, AMZA was aided (and abetted) by a conversation with fund manager Jay D. Hatfield, president and co-founder of Infrastructure Capital Advisors, LLC and co-founder and general partner of NGL Energy Partners LP (NYSE:NGL).4 For purposes of exposition, I will be comparing AMZA to a passive C-corporation ETF: ALPS Alerian MLP (NYSEARCA:AMLP).5
  3. 3. Responsibility for the Actively-Managed Portfolio The fund manager is the primary focus for an actively-managed ETF. In passive ETFs, the management team follows a "roadmap" laid out for it by the fund's index; it may have more or less leeway in choosing how to follow that roadmap, but the basic contents of the portfolio are set for it. The active managers, on the other hand, have the freedom to structure their fund's portfolio according to their best judgment - and this is perhaps the most crucial element for the fund. If the manager is out of step with the target sector/market, or if their skills are not adequately developed, the fund is likely to founder regardless of the manager's best intentions. Skilled managers, on the other hand, are able to bring their knowledge experience to their fund; this may not guarantee success, but it at least makes success more likely. The first consideration, then, would reasonably be AMZA's manager: Jay D. Hatfield. A look at Mr. Hatfield's experience should give us an indication of his abilities:6
  4. 4.  As President of ICA, he manages four other funds besides AMZA: Infrastructure Macro Income Fund, LP; Infrastructure MLP Income Fund, LP; Infrastructure Long/Short Opportunity Fund, LP; and InfraCap Real Estate Income Fund, LP  Served as Portfolio Manager for S.A.C. Capital Advisors (now Point72 Asset Management)  Was Managing Director and Head of Fixed Income Research, Zimmer Lucas Partners  Headed Global Utility Investment Banking at CIBC/Oppenheimer  Was Principal in the Global Power & Utilities Investment Banking Unit at Morgan Stanley & Co. Mr. Hatfield seems to have experience in portfolio management, the energy sector, alternative investment instruments, hedge funds; his involvement with NGL (which is included in AMZA's portfolio) also gives him direct experience in the MLP area. To my mind, this makes him singularly qualified to manage the AMZA portfolio in a hands-on fashion. Flexibility Inherent in Active Management In principle, perhaps the major advantage AMZA (and any actively-managed ETF) has is flexibility - the ability to be able to develop and modify the fund's portfolio according to the manager's perception of economic conditions at the time, rather than in accordance with the structural dictates of an index. Any market - and particularly the oil/natural gas market, of late - is dynamic. The active fund makes it possible for the manager to adjust the fund's portfolio on the fly to accommodate changes in market conditions. In AMZA's case, Mr. Hatfield has done several things with the aim of outperforming the "standard" MLP ETF, Alerian's AMLP. A comparison of the funds' performances since AMZA's inception is presented in the following chart:7
  5. 5. The chart as shown points out two important things:  Both funds have significantly outperformed The United States Oil Fund ETF, LP (NYSEARCA:USO), which has a focus on upstream oil companies; and  AMZA underperforms AMLP by 142bps. As for the first point, while USO focuses on upstream oil, AMLP's index (AMZI) focuses on midstream companies which tend to be less susceptible to the volatility of upstream companies and whose profits are not strictly tied to the price of oil.8 Upstream concerns have been hit hardest by last year's drop in oil prices; midstream companies have been less affected. For its part, AMZA also focuses its holdings in the midstream oil companies; in fact, 24 of its 36 holdings are identical to those in AMLP/AMZI. However, the similarity ends there. AMLP's portfolio is dictated by AMZI, and AMZI weighs its holdings (which are chosen based on distribution) according to market capitalization. AMZA, on the other hand, is weighted according to Mr. Hatfield's perception of each holding's value to the portfolio as a whole; this points to the second consideration: In the actively managed portfolio, assets can be assigned to a holding according to the manager's conception of the portfolio and the expectations for each particular holding in it. Specifically, in AMZA's case, holdings are weighted according to their growth prospects.9
  6. 6. Beyond the MLPs AMZI tracks the performance of MLPs only, and - being tied to its index - AMLP counts among its holdings, 24 MLPs. These may be among the largest midstream MLPs, but AMLP holds only these, and only in proportions consistent with its index. In structuring AMZA's portfolio, Mr. Hatfield added depth to the 24 basic MLPs by investing in companies that were general partners in some of those MLPs (and, in a few cases, putting more weight on the general partner than on its MLP). In all, AMZA's portfolio has general-partner holdings in nine of the 24 MLPs in its portfolio. Has this strategy worked? As I prepared this article, I constructed an informal back-test of the AMZA portfolio (as weighted) to get an idea of how the portfolio's holdings would have performed over the past 5 years. This chart gives the results: (click to enlarge) The portfolio, as a whole, would seem to have done quite well although there is no escaping the 2014 downturn. I then thought to examine AMZA's hypothetical performance in a different way: Compare the portfolio as a whole to those holdings identical to AMLP (call this AMZI*), alongside the "extension" of AMZA's extra 12 holdings (call this Non-AMZI*). To cap the comparison off, I would add AMLP by way of comparing the five-year performance of AMZI to AMZI*.10
  7. 7. The results: Perhaps most notable is the difference in performance between AMLP's use of AMZI and the differently weighted performance of AMZA's AMZI*. This could be taken to indicate that - over time - AMZA has a strong likelihood of outperforming AMLP even if both funds were limited to the same 24 holdings, just by virtue of different weightings.11 Equally important, however, is the effect of the added holdings (Non-AMZI*). Over the past five years, these 12 funds have shown marked value improvement, and that improvement has had the effect of raising the performance of AMZA, as a whole, over the performance of its AMZI* based holdings. The improvement that only seems moderate compared to the dramatic improvement in Non-AMZI* can be attributed to the fact that AMZI* makes up nearly 82% of assets compared to Non-AMZI*'s just-over 18%. Our third consideration, then, is that the added depth to AMZA's portfolio - a product of manager Jay Hatfield's approach to the fund - results in an improvement in fund performance that complements the improvements he introduced with his different weighting scheme. The Impact on Distributions While the extended depth of AMZA's holdings seems to bode well for its future performance, one can argue that it represents a setback to the fund's distributable income. The "basic" 24 holdings account for an annual income for the fund of $396,289.69 (ttm), for an effective yield of 4.58%.12
  8. 8. With the 12 added holdings, the income increases to $457,133.01 for an effective yield of 4.32%.13 This means that, after projected expenses, AMZA would be offering its shareholders a dividend yield of approximately $1.02 per year for a yield of about 4.58%.14 AMLP currently offers a yield of 6.71%. While AMZA's performance might look to be a good bet, dropping 213bps in yield would seem to constitute a serious blow to the fund's active management. However, in January 2015, AMZA distributed $0.50 in dividends to shareholders (dividends are to be paid quarterly). Such a distribution, if annualized, would amount to almost double what I was able to identify from dividends paid by holdings and would constitute a yield of approximately 9%. When I asked if he thought that kind of dividend was sustainable, Mr. Hatfield answered in the affirmative and was quick to bring up an important aspect of his management: He has instituted the use of covered call options to boost fund income. Because of this tactic, AMZA was able to increase dramatically the dividend it was able to offer. Mr. Hatfield expressed confidence that the use of covered calls would enable the yield to remain in the vicinity of $2.00 per share per year.15 Our fourth consideration, then, is the freedom the active manager has of using various investment instruments to amplify the gains - and/or offset losses - the fund's basic holdings may bring about. Even if it were ultimately able to generate half as much as it did for the first-quarter dividends, AMZA would still offer a yield larger than that of AMLP.16 Constructive Use of Leverage Debt is a double-edged sword, as I see it. It enables one to access resources one might not be able to afford on one's own; it also becomes a burden, with interest payments and repayment of principle diminishing one's ultimate return. Debt is one of the things that can cool my enthusiasm for any investment. That said, when used properly, it can help boost a company's (or a fund's) flexibility, enabling it to make quick decisions and moves that can enhance operations. If used judiciously, leverage can be deployed without engendering the fear of reduced future income. ETFs are restricted in the amount of leverage they can employ; the Investment Company Act of 1940 sets a limit of one-third of its asset value as the most a fund can borrow. AMZA currently has borrowed 20%, the funds being used to implement the strategy and tactics Mr. Hatfield deems necessary. This use of leverage, he contends, will enable AMZA to outperform AMLP in the long run,17 and is the fifth, and final consideration we will look at. Assessment At the beginning of this discussion, I claimed that there were five reasons to give an actively- managed fund such as AMZA serious consideration as a holding. Those considerations are:
  9. 9. 1. The experience and skill of the fund manager, Mr. Jay D. Hatfield, at making decisions about the fund's portfolio and operations; 2. the freedom such a fund has in terms of varying the weightings of the holdings in its portfolio; 3. the ability to approach the portfolio's allocation strategy in ways not always accessible to a passive fund; 4. the use of varied instrumentalities to enhance the performance of the fund beyond its holdings and their performance; and 5. the flexibility to employ leverage as deemed necessary to optimize operations. I came away from our conversation with the sense that Mr. Hatfield has a firm vision of the long- term strategies that will bring about the growth in share value and the growth in distributable income that could make AMZA a valuable part of any portfolio. Points 2-5 above constitute Mr. Hatfield's three reasons why he believes AMZA will outperform AMLP by at least 300bps, and as high as 500bps (he lumps 2 and 3 together while I see them as two different strategies). In terms of the added costs, both active management and operation as a C-corporation entail, this is a judgment each individual investor will have to answer for themselves. If the use of covered calls is able to consistently boost distributable income, and if the oil market meets Mr. Hatfield's belief that oil will be going for more than $60.00 per barrel in the next year,18 both yield and performance should give a substantial total return for the investor. I am not sure that the share value of AMZA will appreciate quickly, as the general oil situation is still somewhat unstable, and instability in price and supplies of oil will keep upstream and midstream stocks down. Further, with the Fed getting closer to committing to a rate hike, the impact of such a hike on MLPs, their general partners, and AMZA itself, will be indeterminate. I do see an upside to AMZA, and perhaps one in keeping with the roughly 20% increase Mr. Hatfield sees in the price of crude. That AMZA is a young fund may mitigate its performance somewhat, but a consistently high distribution would offset any downside. Long term, I think this fund has excellent potential, that potential contingent on maintaining Mr. Hatfield (or a comparably skilled replacement) as its manager. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company's published documents to the extent possible. All tables, charts and graphs are produced by me using data acquired from pertinent fund information; historical price data from Yahoo! Finance. Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views.
  10. 10. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 "C-Corporation MLP ETFs: Why Wait?" 2 For a discussion of the tax burden assumed by the C-corporation ETF refer to the early portion of the article noted in #1, above. 3 Keep in mind that the passive fund is "managed" on a quarterly basis, usually; an active fund, on the other hand, can engage its management team as often as deemed necessary. Further, rather than following an index, the active fund management develops its own, proprietary, method of portfolio management. This "extra" engagement of management comes at a price. 4 Jay D. Hatfield and I engaged in a phone interview on February 18, 2015. All references to Mr. Hatfield refer to that interview. I thank Jay for taking the time to talk with me. 5 AMLP was considered the superior fund of those considered in the earlier article (#1, above). The data in this table is updated from that in the earlier article, using data from the Annual Report of November 2014. In particular, AMLP's E.R. is cited as being 8.56% while I was able to calculate an E.R. of 5.09% based on the data provided in the recent AR. Any error in calculation is mine, and is regretted. For reasons that will be clear as the discussion progresses, Mr. Hatfield encouraged the comparison of AMZA to AMLP's index, AMZI. 6 Information culled from Infrastructure Capital Advisors' biography, viewable here. 7 United States Oil Fund LP is included to provide comparison to near-month crude oil futures. 8 Upstream companies are involved in exploration, drilling and extraction. Midstream companies are focused on the transportation, processing and storage of oil. 9 Per phone conversation, #4 above. 10 In principle, this pits two versions of AMZI against each other. The difference between the two would (again, in principle) be the different weighting systems used: AMZI's cap-weighted scheme to AMZI*'s "prospect-weighted" scheme. 11 Of course, the standard disclaimer applies: past performance does not imply future performance. 12 That is, the yield it realizes from its holdings. 13 Again, the yield AMZA realizes from its holdings. By themselves, the 12 additional holdings realize an income of $60,843.33, amounting to a yield of 3.16%
  11. 11. 14 These figures are based on the stated E.R. of 1.05% subtracted from projected income, then divided among shares outstanding. AMZA currently has 350,000 shares outstanding. The reader should realize that these figures represent estimates on my part based on available data, and do not claim to be representative of the fund's actual income. 15 Per phone conversation, #4 above. It is worth noting that covered calls have the potential to bring about costly losses, as well as substantial gains. 16 It should be pointed out that, as I researched dividend payouts for the MLPs held by AMZA, nearly all of them showed gradual, consistent, increases in distributions as the past 12 months played out. 17 Per phone conversation, #4 above. According to Mr. Hatfield, AMLP is leveraged to only 10%. 18 Per phone conversation, #4 above.