Most income investors will know at least a little about Master Limited Partnerships more commonly referred to as MLPs. Most MLPs are tied to the transportation of energy products. They collect royalties as the energy product moves through their pipeline (this is a very common structure). Fundamentally, the movement of MLPs should not be vulnerable to price movements of the underlying energy product. The royalty collected is what it is.
This is the generally accepted truthism about MLPs and most of the time it is correct but not always. The following chart from Google Finance tracks a large MLP exchange traded product in blue versus a large energy sector ETF in Red, we’ll get to the yellow line in a moment.
The royalties may not change but the price action of the two look very similar. In past declines MLPs have many times been spared but not always as was the case over the last month. You might think of course they will snap back and while that will probably turn out to be correct, someone sold at the lows, perhaps in a state of heightened emotions and now likely regrets (another emotion) the sale.
Of course MLPs could be vulnerable to lower demand; less oil moving through the pipeline would result in less royalty income.
The yellow line is a relatively large Business Development Company (BDC) that had a similar even if not exact decline as the MLP fund during the essentially the same period of time. The charted BDC was not an island, one of the BDC ETPs was down in lockstep with the charted individual name. Again, there has been snapback in both but also again, someone sold at the lows.
We often see articles published in numerous places suggesting very large weightings to various income vehicles including MLPs and BDCs. Someone who put 15% in each increased their chances of being put in a position where they panic sell. It is much easier to be rational now after the worst of it (or maybe now is just a respite) than during the heat of the decline.
Look at the correlation of MLPs and BDCs as measured by the respective ETPs there seems to be no rhyme or reason here, sometimes they correlate closely and sometimes the correlation is negative so it is probably a coincidence that they both went down at the same time and it might be a rare event that MLPs go down under the weight of a drop in oil prices but both happened and both happened at the same time.
This sort of unfortunate coincidence can happen at any time with any market segment. REITs did not go down with the other two this time around but what if they did and in addition to 15% in the other two the same investor had another 15% in REITs?
MLPs, BDCs, REITs and any others are valid portfolio exposures, the point here is about weighting. Most of the time these things do what investors hope they do but that won’t matter if you give in to a panicked decline. Everyone has their own threshold for capitulation and as I have said many times before finding out you too much in fill-in-the-blank after it goes down a lot is a very bad place for an investor to be.
Any market segment can have some sort of event that even if unjustified fundamentally can still do permanent portfolio damage to the investor whose panic threshold is breached. This is why diversification and emotional control are both so important to long term investing success.
This article was written by AdvisorShares ETF Strategist Roger Nusbaum.