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Energy Stocks

Don’t Buy the Index, Buy Stocks

By Elliott H. Gue, on Apr. 14, 2014

Jan. 29, 1993 was an important day for the US market.

It’s not that the broader market saw a big move: The S&P 500 rose an insignificant 0.12 points and the Nasdaq managed to eke out a gain of a little over 2 points.

Nor did interest rates move much – the yield on the 10-year government bond fell from 6.39 to 6.36 in a quiet session.

And commodity markets were also uneventful, with oil down about 1 percent to just $20.26/bbl and gold up $3 to $332.5 an ounce.

However, that late January day 21 years ago was the launch pad for one of the most popular financial tools in market history. Today this asset class holds over $1.67 trillion in net investor assets.

Expectations at the time weren’t high. An official for the American Stock Exchange, where this product was listed for trading, was quoted saying that the exchange would be happy if the new listing managed over 100,000 shares traded on its first day and they hoped it would catch on with individual investors over time.

As it turns out, the new product traded on volume of a little over 1 million after its initial offering, about 10 times what the exchanged had hoped. But that was only a shadow of what was to come – today this product averages volume of well over 100 million per day and routinely sees 300 million or more units change hands.

In the month of December 2008, volumes approached 27.6 billion shares.

Of course, I’m talking about what’s now known as the SPDR S&P 500 exchange-traded fund (ETF) trading under the symbol “SPY.”

Spider Senses

Launched in early 1993, this was the first ETF listed on the US exchanges and was designed to track the performance of the S&P 500 Index, the most widely used benchmark of US stock market performance.

According to the Investment Company Institute (ICI) there are now nearly 1,200 ETFs traded in the US alone tracking everything from stock indexes to commodities and the bond market. As I noted earlier, total assets invested in US ETFs have soared to nearly $1.7 trillion.

Source: Bloomberg

Aiding the growth in this asset class has been heavy marketing spending on the part of financial institutions that issue these ETFs and earn fees for managing funds.

And given that popularity and the attention ETFs garner through marketing, it’s hardly a surprise that I’m often asked if there’s a way to track our strategies and recommendations solely using ETFs.

The answer is a resounding NO.

It’s not that I have an issue or objection to ETFs in general. I’ve personally owned and traded ETFs and options based on ETFs on many occasions. And the product makes a lot of sense: by purchasing an index of stocks through an ETF, investors can get instant diversification, all for a single commission. Management fees are usually modest in comparison to fees charged by mutual funds.

Moreover, some ETFs allow retail investors to access investments and asset classes they could not otherwise participate in. Examples include ETFs tracking the performance of tough-to-trade emerging or frontier markets like India or Vietnam. Another example would be ETFs tracking foreign bond markets and currencies.

In short, ETFs are a useful tool for investors.

That said, these exchange-traded products also have some significant shortcomings; in virtually all cases, I believe investors can earn superior returns by investing in individual stocks rather than a fund or ETF.

A classic example is the Master Limited Partnership (MLPs), a high income group we cover in Capitalist Times Premium’s sister publication, Energy & Income Advisor.

Why I Love MLPs

MLPs offer two major advantages for investors: high yields and tax deferral advantages. The average MLP yields around 6 percent and a large portion of your annual distributions are not taxed until you sell the MLP, allowing investors to defer most of their tax liabilities for years and, in some cases, indefinitely.

In Energy & Income Advisor we publish two model MLP portfolios, one aimed at conservative investors and one aimed at more aggressive investors willing to put up with more volatility to earn a higher average yield.

We also cover every single publicly traded MLP in our coverage universe, offering buy and sell advice for subscribers looking for advice on MLPs not currently part of our model portfolios.

The Alerian MLP Index is a widely watched benchmark of the industry’s performance and includes 50 of the largest publicly traded MLPs.

The Alerian has performed spectacularly well over the past five years, generating gains of about 275 percent or over 27 percent annualized. Over the past year, the Alerian has returned a solid 13.7 percent, though that’s significantly worse than the S&P 500’s 20 percent gain over the same time frame.

Nevertheless, many ask me if the JP Morgan Alerian MLP ETF (NYSE: AMJ) – an ETF tracking the performance of the Alerian – is a reasonable alternative to buying the individual MLPs we recommend.

The problem with the JP Morgan Alerian product, is a flaw shared by most publicly traded ETFs: The fund is weighted by market capitalization. That means that the largest MLPs account for a disproportionate share of the ETF’s performance and assets. In this case, the 7 largest MLPs account for almost 52 percent of assets in the ETF.

Sadly, some of our favorite MLPs are smaller names that account for only a minuscule share of the Alerian ETF or, in many cases, are too small to be included in the index.

An example includes Hi-Crush Partners LP (NYSE: HCLP), an MLP we recently sold from our Model Portfolio to book a more than 60 percent gain since our recommendation in September 2013.

The publicly traded partnership operates silica sand mines in Wisconsin that produce proppant, a critical component in hydraulic fracturing. This crush-resistant sand ensures that the cracks created during the fracturing process remain propped open, facilitating the flow of hydrocarbons into the well.

In recent quarters, several producers have indicated that upping the amount of proppant in their fracturing fluid has improved recovery rates–great news for Hi-Crush Partners, which enjoys the industry’s lowest supply costs.

At the time of recommendation, Hi-Crush Partners yielded 7.7 percent, about 1.5 percent more than the average MLP and the stock has outpaced the Alerian MLP Index by nearly 53 percent since our recommendation.

However, Hi-Crush is a small MLP that’s relatively obscure and not as widely followed as large-cap names like Enterprise Products Partners LP (NYSE: EPD). It’s not even a component of the Alerian Index so purchasing the Alerian ETF would have given you no exposure to the strong gains in this stock.

Smaller, under-the-radar MLPs are the main reason the MLPs in our model portfolios are handily outpacing the Alerian Index over an equivalent holding period. You won’t find these names in the ETF.

If you’re interested in learning more about our favorite high-yield MLPs, now is a great time to try a risk-free trial to Energy & Income Advisor. There’s still time to join this month’s exclusive, subscriber-only chat where Roger and I will answer all of your questions about stocks, commodities, the economy or any other topic you’d like to address.

Last month’s exclusive chat lasted over four hours and we answered close to 100 questions.

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