Income-minded investors interested in the potential growth opportunity of the rebounding energy segment can consider sector-specific ETF strategies to gain targeted exposure to market segments.
On the recent webcast, Portfolio Construction: Where Do Sector ETFs Fit?, Todd Sunderland, Partner, Head of Risk Management, Head of Quant Strategies, Cushing Asset Management, listed a number of reasons why investors would consider taking a sector-specific ETF approach, including classic considerations such as time horizon, risk tolerance, strategic goals, tactical allocations and return goals, among others. The sector strategies should compliment an investor’s broad market, other sector and stock specific holdings.
As investors look to the energy sector, we can further breakdown the components into even finer parts. The energy supply chain covers energy service, exploration and production as part of the upstream segment. The midstream segment is comprised of energy infrastructure such as transportation, storage, processing and refining. Lastly, the downstream segment is comprised of energy consumers and converters, including residential, utilities, industrial, chemical and transportation segments.
Looking ahead, Sunderland argued that production increases could moderate form here while the need for infrastructure remains to transport the rising production. Oil prices over $50 have historically been generally supportive of continued production growth. Meanwhile, the Organization of Petroleum Exporting Countries have cut supplies, which contributed to a tightening market.
Nevertheless, Sunderland warned of potential risks such as a recession, currency moves, trade policy and environmental or governmental policies.
As a way for investors to better focus on areas of interest in the energy sector, Cushing has recently come out with a handful of its own master limited partnership-related sector ETFs, including the Cushing Utility & MLP ETF (XLUY), Cushing Energy & MLP ETF (XLEY), Cushing Energy Supply Chain & MLP ETF (XLSY) and Cushing Transportation & MLP ETF (XLTY).
XLUY seeks to track the performance of the Cushing Utility Index, which includes constituents from S&P 500 Utilities Index and Cushing 30 MLP Index. XLEY seeks to track the performance of the Cushing Energy Index, which includes constituents from S&P 500 Energy Index and Cushing 30 MLP Index. XLSY seeks to track the performance of the Cushing Energy Supply Chain Index, which tracks constituents from S&P 500 Energy Index, S&P 500 Materials Index and Cushing 30 MLP Index. Lastly, the XLTY seeks to track the performance of the Cushing Transportation Index, which holds constituents from Dow Jones Transportation Avg. and Cushing 30 MLP Index.
To improve tax efficiency, these MLP-related ETFs limit exposure to MLPs to 24% at each quarterly rebalance. Traditional MLP funds that hold more than 25% of their portfolios in MLPs are structured as C-Corporations and must pay corporate income tax on distributions before passing them on to investors, which incurs additional tax headaches come tax season that translates to lower overall returns.
Sunderland argued that midstream and MLP businesses are included in the ETF strategies because the segment is fundamentally related to the sector company businesses, can potentially increase yield generation and are historically excluded from S&P 500 and Dow Jones Averages, providing another layer of diversification benefits.
“We believe that these sectors are vital to the U.S. economy and thus may be appropriate for portfolio inclusion,” Sunderland said.
Furthermore, the sector focused ETFs come with an income tilt, paying a monthly distribution. The strategies seek income from a variety of sources in portfolio construction, which may be beneficial as it could provide income for dollar cost averaging in reinvestment programs or for other uses.
“When evaluating similar ETFs, we suggest not only evaluating their total expenses, but the ETF construction and also yield subtracted by the total expenses,” Sunderland added.