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Posted by on Feb 9, 2017 in ETF Strategist, Market Insight

Turns Out MLPs Are Risky

Turns Out MLPs Are Risky

By Roger Nusbaum, AdvisorShares ETF Strategist

Over the weekend, Barron’s had an interesting article on Master Limited Partnerships (MLPs). What is interesting to is the almost hindsight bias of the risk assumed with MLPs.

From the Barron’s article:

But lower energy prices are the biggest risk for the MLP bull run. “If investors don’t realize that, they’re missing the forest for the trees,” says Hatfield.

It may be difficult to remember, but there was almost no one saying this ten years ago. Since the assets owned by MLPs are mostly pipelines and storage, the price of the underlying doesn’t matter was the general argument. The yields were generous and the belief was that the volatility was low. Here is a link from 2012 by a well-known advisor explaining why a 15% allocation to MLPs was conservative. If you spend enough time you will find old articles and posts arguing for 20% in MLPs. Note, I am not trying to pick on the advisor, the post simply captures a prevailing viewpoint from back then.

This is a link to a discussion thread on Morningstar and near the top is someone who has “62% of my assets in MLP’s. I have a very concentrated portfolio, BUT I watch it very closely.” That was in 2010. He could have sidestepped the crash, but what do you think the odds are of that?

I’ve always thought that a huge weighting was a terrible idea. A general rule of thumb that I picked up somewhere along the way very early in my career and repeated quite a few times on the blog is that something with a relatively high yield, like MLPs, is risky and if you don’t think it is risky then you don’t understand the risk. This is not to say you should not take the risk but you need to understand it and anyone understanding the risk probably wouldn’t have had 20% in them.

Here is one post of mine from 2006 and another from 2012, but there are countless others, that are related to keeping allocations to MLPs small. It is the same argument for having a small, as opposed to large, allocation to gold or REITs. Now that REITs are their own SPX sector though, it becomes easier to benchmark to. The S&P 500 currently has a little under 3% in REITs. It is easy to assess that a 20% weighting to REITs is a massive overweight.

One of the larger MLP ETFs went on a 16 month, 45% slide when energy prices crashed and is up about 50% over the last year. There obviously were a lot of higher yielding MLPs that are no longer with us but a 20% allocation to something that cuts in half in a mostly flat environment for equities generally creates a huge drag and is not the type of action anyone expects from one of their “conservative” holdings. That sort of volatility is probably appealing to various types of traders but for the typical investors looking to add a little yield, down 50%, up 50% (so still down 25%) is not what they want with a large chunk of their portfolio. Having a holding with a 4-5% weighting drop that much is certainly a bummer but in a diversified portfolio that includes individual issues there is likely to be something down a lot and something else that is up a lot, it’s not a scary place to be.

Investors held REITs in similar esteem before the financial crisis and the two big ETFs that were around back then each fell 72% at their worst. Again, it is not that they should necessarily be avoided but these are high yielding, narrow exposures and loading up on them is very risky and to quote myself, if you don’t think they are that risky, then you don’t understand the risk. This is now accepted about MLPs and REITs but there will be other segments that will gain this sort of popularity and it will still be true.