MLP ETFs & Income Strategies, With Jay Hatfield

Master limited partnerships (MLPs) hold massive appeal for High Net Worth investors seeking tax-advantaged income. But it is better to invest into an individual MLP, or to seek more diversified exposure with a fund?

Jay Hatfield, founder and CEO at Infrastructure Capital Advisors (InfraCap), joins the show to discuss how ETFs offer High Net Worth investors efficient and diversified access to the MLP asset class.

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Episode Highlights

  • How Jay got his start with MLPs and energy investments.
  • Details on InfraCap’s Inflation Indicator, the Real Time Consumer Price Index/CPI-R.
  • An overview of the MLP asset class, and why MLPs may be an attractive investment for High Net Worth investors.
  • The different tax advantages associated with individual MLPs, versus ownership of an MLP fund.
  • Why preferred stocks could be considered as an alternative investment, and why this asset class offers strong value at the present time.
  • Details on AMZA (the InfraCap MLP ETF), and PFFA (the Virtus InfraCap U.S. Preferred Stock ETF).

Today’s Guest: Jay Hatfield, InfraCap

About The Alternative Investment Podcast

The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.

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Show Transcript

Andy: Welcome to “The Alternative Investment Podcast.” I’m your host, Andy Hagans. And today we’re talking about MLPs, liquid alts, income investing, a variety of very timely topics. And joining me is Jay Hatfield, who is founder and CEO at InfraCap. Jay, welcome to the show.

Jay: Thanks Andy for having me on.

Andy: Yeah. And so, this episode is part of our series on alternative ETFs and liquid alts. And Jay, I wanna dive into all that, MLPs, your ETFs, but why don’t we start with your background. Could you tell us a little bit more about your career?

Jay: I’m from California originally. I have a degree in business and economics from University of California at Davis, CPA from Ernst & Young in San Francisco, an MBA in finance from Wharton in Philadelphia. And then worked the last 33 years on Wall Street, about half of that time as an investment banker, mostly at Morgan Stanley, doing utilities and MLPs in energy. And the rest of the time on the buy side, most recently, the most relevant would be as a portfolio manager for Steve Cohen’s S.A.C. Capital at the time, now 72Point. He’s the owner of the Mets. I ran a billion-dollar fund for him, fixed income and equity income fund. I started my own MLP with one of my ex-clients. We took that public in 2011. And then, over the last 10 years, we’ve launched our hedge fund, and then our four ETFs that we’re gonna talk about today.

Andy: Wow. That’s just a little bit of everything there. Well, the hedge fund, MLPs, ETFs. Okay, great. So, wow, there’s a lot to unpack, but before we even get into that, I was reviewing your all website, the InfraCap website, and I think it’s a timely topic. You know, so many investors are looking for income, and, you know, especially in the past couple years. Bonds are yielding a little bit more, obviously, now, but still, in general, I think investors have been starved for income, and one of those reasons is inflation, right? And your website has this section with an inflation indicator. It’s the real-time consumer price index, the CPI-R. Could you tell us more about that?

Jay: Yes. The reason that we developed it… So, we do a lot of macro research, which we think is important, because if you don’t get the macro correct, then you’re probably not gonna get the asset allocation correct. And so, I’ve studied the Fed, really, since I was at Davis. I studied under a monetary economist. And so, I became very, very concerned about our Federal Reserve. They’re very focused on the labor market, and they, in our opinion, about a year and a half ago, were really missing the fact that inflation was accelerating. And if you break down inflation in the ’70s, it was driven by two things, loose monetary policy, which creates housing inflation, you know, lowers interest rates, low mortgage rates creates housing inflation. And then two, gigantic energy price shocks.

So, that’s exactly the situation we had in this inflation we’re experiencing, but the Fed was focused on the labor market, which still had slack in it during late 2020-21. So, what we realized recently is that the Fed had just looked at the way we used to calculate CPI. So, prior to 1982, for shelter and housing and rent, we just used housing prices, which was completely rational way to do it. It created some agita among politicians and consumers because it was more volatile. Then we slowed it down, but then CPI became useless. Or not useless, but hugely lagged by 12 months, because housing prices lead rents and shelter as calculated by the BLS, by 12 months. But, it’s 70% correlated.

So, a much more effective way, and what the Feds should have done, is use CPI-R, which isn’t really proprietary, because, like I said, we’re just going back to the way they did it in 1981, roughly. But if they had done that, it hit nearly double-digit annualized rate in late 2020. So it would’ve been an enormous, you know, risk factor, or sign, that the Fed should be tightening. But they completely ignored it, you know, because shelter is 33% of headline inflation and 41.7% of core. So, the fact that the Fed was just focusing on the labor market was an abomination, but it still is, because now, we do have deflation. Our index is in strong deflationary mode, but CPI is increasing. So, it’s much better. There’s a 70% correlation between our measure and CPI-U out 12 months. That’s just all urban consumers. So, that’s what the Fed should be looking at, so that’s why it’s really critical for investors to look at that.

Now, we’ve been, before the year started, way more optimistic than most about inflation, and that’s really already playing out in the markets. Like, we recommended buying… We thought that the 10-year was gonna go to 3% by the end of the year, to be fair, not the first 5 trading days of the year, or 10 trading days. But we have seen kind of a global recognition, except for the Fed, that inflation’s declining, which is driving long rates down, and causing a lot of the securities that we own in our ETFs and like to trade, to rally, particularly preferred stocks, REITs, and to a lesser degree, MLPs. MLPs are more sensitive to energy stocks.

So, I would urge your viewers to focus on, you know, shelter and energy, and just recognize the Fed’s gonna be about 12 months behind. They’re very intelligent people, have PhDs, except for the Fed Chair, but they focus on the Phillips Curve, or in other words, they assume that all inflation comes from the labor market, which is just not what history tells us. It’s really housing and energy are the key drivers of high inflation, at least. So, that’s what gave a rise to that index. I would strongly recommend people look at it, and just recognize it’s completely standard things here. It’s not like we came up with something exotic. It’s just going back to a more effective way of calculating inflation.

Andy: Yeah. Apples to historical apples. So, it sounds like this index, and you at InfraCap, were ahead of the curve understanding, with some other people, but ahead of the curve, understanding that we’re already seeing disinflation, you know…

Jay: Correct.

Andy: …leading indicators. Were you also ahead of the curve in 2020, like…

Jay: We were. I mean, I even tried to get the press, in the first quarter, when the Ukrainian energy prices ran up… Because there’s one other factor the Fed never… Actually, they have a Fed paper that validates this, but they never talk about it, is that there’s a 5% bleed-through of energy prices to core. So, you know, when you say core… “Oh, well, core, you know, is super-hot,” but, I mean, core is cool, but, you know, headline is super-hot. Well, you should just be thinking if that just started, well, actually, some of that’s gonna bleed through to core. And you might say, “Well, how could that be?” Well, the most obvious example is airline fares. That’s in core CPI, but it’s 40% driven by energy prices. So, if you really think of all businesses in the core services area, there’s almost no business that doesn’t consume some energy. But some are very high. Like, energy price inflation drives food prices higher, because fertilizer is 60% natural gas.

So, we were in full-mode panic in the first quarter of ’21. And in fact, I remember we had a real-time gauge that was different than CPI-R, but we were estimating run rate inflation was 10%. You know, so mark-to-market inflation was 10% in that quarter. And we tried to get the press to be interested, and they just didn’t care.

Andy: Hey, good luck.

Jay: There’s a little bit of a political element to it, because inflation was being used by the opposition party to try to derail a lot of spending plans. And so, I think they kind of got caught up in politics a little bit, so that’s a reason, but not because we speak to God…

Andy: Jay, surely, you’re not telling me that the media is influenced by political or ideological consideration?

Jay: It’s not possible. It’s not possible, because they take an oath that they’re independent.

Andy: Sure.

Jay: It’s definitely not possible. But for some reason, I don’t know exactly why, they weren’t interested in the inflation story. Our insight, both then and now, is not because we speak to God, but simply because, you know, I was trained by a monetarist… And look, I believe in the labor market as well as a critical element in the economy, but Chair Powell said publicly the money supply does not matter. And that’s just not correct. If you raise the money supply 65%, like they did, then you’re gonna have inflation. You know, it’s gonna show up in housing, because you drive mortgage rates to all-time lows, but it shows up other places as well. But then, this year, very few people appreciated that the monetary base declined by 17% almost before the Fed…and it started declining before the Fed raised rates, because they had to use open market operations because rates were gonna go below zero. So, same thing. You can’t ignore a 17% decline either.

Now, truthfully, there could be other markets, like, for instance, going into the pandemic, it would be of course virtually insane to ignore the labor market going into pandemic. Because the monetary policy was steady, so it was an example… So, we look at both indicators, but when one indicator, like, when the money supply is super volatile and the labor market’s relatively stable, then the money supply is more important. If the labor market’s super volatile like the pandemic, then it’s more important, so you should really look at both. But we have a myopic Fed, which creates risk, but we’re relatively copacetic about the economy despite the incompetent Fed, in our opinion.

Andy: Yeah, it’s interesting. They are, you know, in theory, trying to manage risk or mitigate risk, and yet they help create risk, you know. Well, okay. So, that actually brings me to kind of our main course, so to speak, of this conversation. You know, against this backdrop of the past few years, I mean, investors, real estate investors, or just, you know, retirees, anyone managing a family office, it’s been a very challenging environment for a variety of… You know, challenging this past year in some different ways. But the low-rate, and the, you know, low-income, low-yield environment for a long time, that created its own set of challenges.

And so, in that context, I wanna talk about master limited partnerships. So, obviously, you know, you have an ETF in that space, and a lot of our audience of advisors, high-net-worth investors, are already invested in MLPs, but I’m guessing that there’re some folks in our audience who aren’t investing in MLPs, or, you know, maybe they know about them but don’t really understand all of the benefits. So, why don’t we start there? You know, what are the benefits of MLPs for high-net-worth investors, for family offices? Is it all about tax efficiency, or, you know… Sell me on MLPs, I guess is what I’m asking.

Jay: Well, it’s really two elements. So, clearly there’s a huge tax benefit, and we can get into some of the details, and it helps. It is complicated because partnership accounting is the most complex element of tax accounting, but I’m a CPA and I’ve founded an MLP, so we can talk about that in whatever depth you’d like. But the most important thing, and investors kind of painfully learned this over the last five years, is that you have to start with the companies, and what’s the status of the companies, and what’s the status of the energy market.

So, a lot of your viewers might have been burned by MLPs, and that really was driven over the last five years. So, it was driven by two things. We had a crash in energy prices. We were over $100 about 5 years ago, went down to $20, and of course, we had another one during the pandemic. And so, what that forced… These companies are very solid companies. Most of them have national footprints. They have significant natural gas assets, which is a key transition… It’s controversial, a little bit, more so two years ago, but natural gas is a critical transition fuel, and Europe has kinda learned that lesson very painfully.

Andy: Yeah. I hope no one disagrees with that now in 2023.

Jay: I mean, there’s still some controversy in, you know, certain states are banning the use of natural gas, which is a little bit silly because all you’re doing is burning the natural gas somewhere else. Like, if you don’t burn it in your house, you have to burn it, at the margin, to generate electricity. Because, I mean, not to get too much in energy, but you are in energy if you’re buying pipelines.

Renewables, I’m a big fan of renewables. I was one of the first… No, I was actually the first renewables investment banker on Wall Street, 32 short years ago. And what I can tell you from that is it’s a great technology, wonderful for the environment, but it’s very hard to ramp it up quickly, as evidenced by the fact I was, started doing renewables, did deals for, which is now a defunct company, but Ballard Power, and a lot of fuel cell companies, and solar companies. But it just takes a very, very long time. So, that was 30 years ago when I was doing those first offerings, and now renewable is about 4% of total U.S. energy usage. Not electricity, but total. So, it includes transportation fuels.

So, it’s not a magic bullet. It’s wonderful. It’s great for the environment at the margin, but you cannot… The most important thing if you’re an environmentalist, and I am, is to get rid of coal, which is controversial, but required, by developing more natural gas. And the U.S., we’ve done that substantially, and that’s why our emissions are down about 15% to 20% over the last 20 years. Whereas in China, they’re building a tremendous 40 gigawatts of coal-fired capacity. So, it would be better if we developed our natural gas, shipped it to China, and they didn’t have to build that coal capacity. But so, in any case, to your point, I think it’s becoming more accepted that natural gas is a key transition fuel. Most of the companies we own have big natural gas exposure. They also have oil exposure, but we’re gonna continue to use oil for quite a while. So, the fundamentals are good. We project oil to be $80 to $100 this year, so we’re at the low end of the range right now, as China reopens and we continue to have a shortage of natural gas at some level.

So, the energy market’s good. The other element to this, and I’m glad this is a longer interview, because MLPs are complicated, but the companies were in growth mode. So, what they were doing in 2015 is saying, “Oh, we’re growth companies, so we’re gonna issue equity, pay out all of our free cash flows, dividends, and we’re just going to hope that the equity markets are strong so we can fund our growth.” But what happened is when energy crashed, and, you know, when hedge funds started shorting MLPs because they knew they did equity offerings all the time, the companies had to restructure, which is what they’ve been doing over the last five years. Not, like, in bankruptcy-type restructure, but they needed to reduce their payout ratios, increase their credit ratings, decrease their leverage ratios.

And they’ve done all that, and reduced their growth, so they do grow, but limited growth. And so now all the companies are exactly what every investor should look for. They have high coverage of dividends, they buy back shares, so if the market’s weak, they benefit from it instead of having hedge funds short their stock and benefit from equity offerings. And they’re growing their dividends now. They were declining for most of the, over the last five years, they were declining about four of those years, and just the last year, they’re increasing. So, the fundamentals of the asset class are now strong. And, because there were so many people burned, they’re very cheap relative to historical, and I would argue relative to other asset classes. Still, even after outperforming last year dramatically.

Andy: So, strong underlying fundamentals, and also trading at a discount, so that they’re a value buy. And from my understanding, these are pretty tax-efficient vehicles for…

Jay: Yeah, so that’s the second element, that’s a little bit complicated, but understandable. And that is that these companies, they do still grow at some level. And because of the way that we’re moving away from full expensing, because that didn’t get renewed in the last Congress, but there’s still what’s called MACRS depreciation, or accelerated depreciation for long-lived assets. So, if you think about a pipeline, you build a new pipeline that lasts 30, 40 years, but you write it off over 5 to 10 years, for tax purposes. So, each of these companies has strong earnings, but they have excess tax depreciation that shelters it from a tax perspective.

So, they’re able to pay out a lot of cash. The yields average, you know, in the seven to eight range for most of these companies. But then, if you’re an individual investor and you don’t buy our fund or similar funds, you get a what’s called a K-1. That’s a partnership return, which is complicated. Very few people would be able to do that, file that themselves, so you have to pay your tax accountant to file it for you. But in that K-1, what you’ll see is, “Oh, I got a lot of cash distribution,” so the 8% yield, “but I don’t owe any significant tax.”

Andy: Yeah, so, you know, you get that benefit. That’s kind of, the K-1 is a pro and a con, right?

Jay: Right. Yes.

Andy: It’s a con because it’s complexity, but on the other hand, you know, a lot of accredited investors, family offices, you’re already getting a dozen K-1s, or I guess for a family office you might be getting 100 or more K-1s, so, you know, what’s one more? So, when you wrap… I guess, if you put multiple MLPs into a fund, or, like, another intermediary wrapper, as an investor, do you still get those tax benefits, or?

Jay: Well, you know, this is also complicated, but therein lies the opportunity. Normally, there’s a lot of benefits. So, we are structured. AMZA is structured as a corporation, as is the largest ETF as well. We’re an ETF. So, with a corporation, normally there’s give and takes. So, what’s positive is, the bad thing about getting K-1s is that if you sell the investment, and most people ultimately will, then you get what’s called recapture. So, that excess depreciation I was trying to describe gets treated as ordinary income, not dividend income. So, holding in a corporation is great from that perspective, and you get no recapture, and, you know, to your point is correct, that not getting K-1s is more important for small investors, because there’s diseconomies of scale. You know, like, I also have a very complicated tax return, so getting one more K-1 is not gonna move the needle on how much I pay. But if you’re a small investor and you have a very simple tax return and you get one K-1, it’s a problem.

But what also happens, so, by having an incorporation, if there is any taxable income, it becomes qualified dividends, which it would not be in a K-1. It would be just ordinary income. So, converts any ordinary income to capital gain…I mean, to qualified. But then also, if you sell it after a year, you get capital gains treatment instead of that recapture. So, that’s very, very positive. Now, to be fair though, and the largest ETF has this problem right now, that the offset is that from an accounting perspective, the corporation, which is, in this case, our ETF, or the big ETF, if you’re in, don’t have a big, large, deferred tax offset, you have to accrue for taxes. So, if MLPs rally by 10%, then the NAV would only go up roughly by 80, because you’re accruing for 21% federal corporate tax.

Andy: I see.

Jay: And so, it’s a big drag on your return. So, when you do the analysis of those two factors, it may be slightly better to be a corporation. But if you don’t mind filing K-1s, it’s a little bit of a breakeven. Depends on when you sell it of course, and, you know, when you get that recapture.

Andy: Understood.

Jay: But what investors should look for, and because we launched our fund in 2014, we have a situation where we have about $17 of deferred tax assets, gross. So we don’t have to accrue until roughly, we’re at roughly $32, we don’t have to accrue for taxes inside the corporation till we get to about $50.

Andy: Wow. Okay.

Jay: So, you might have noticed…

Andy: Yeah. Sorry to interrupt. So, I mean, it kinda sounds to me like, you know, buying individual MLPs, I’m getting certain tax benefits.

Jay: Right.

Andy: But, if you design a fund intelligently, or put multiple MLPs in another wrapper like an ETF, intelligently, there are other tax benefits. And so, I wanna shift now to talking about your ETF, some of the details here. So, this is AMZA, the InfraCap MLP ETF. And I’m reading from my notes, “The fund seeks to provide exposure to midstream MLPs with an emphasis on high current income.” So, tell us more about this specific ETF. Is this the best way for investors to get exposure to this specific asset class?

Jay: Well, you know, if you have, like, just one MLP that you love, and you just wanna do that. But if you want a diversified portfolio, I would argue that it’s superior. And, you know, we, of course, have tremendous amount of research. We actually hire outside firms to validate our research and get into even well-level data. So, we’re doing…and we’re talking to companies every day. We were one of their largest holders, so, you know, they love talking to us and we go to all the conferences. So, that gives us an advantage in picking stocks.

Andy: So, you’re doing due diligence like a family office might do on a private energy investment or something. You’re doing that…

Jay: Absolutely. And we’ve been doing it for now, you know, nine years, and roughly the same companies. So, you know, my partner, who founded our MLP, was a co-founder of Energy Transfer. So we know the companies extremely well. Now, having said that, there’s no magic bullet in MLPs. They tend to trade together. We take advantage of certain, you know, outperformances, underperformance. But, and it’s actually an argument for having a diversified portfolio, because you might love Energy Transfer, but then you notice, like, “Oh, I guess, you know, Enterprise and Plains went up to the exact same amount.” Well, why is that? Well, they’re pretty well-correlated.

Now, we optimize it, and take advantage of anomalies, equity offerings, other things that happen, so we think we can beat the index, but the most important thing right now is that deferred tax asset. And again, it’s not because we’re brilliant or great structures. We’re actually sort of the reverse. We launched the fund in 2014, when oil was at $100, so we have tremendous tax benefit assets that don’t…for accounting purposes, they get reserved against. So, that’s why, like, our fund would be arguably, at least from a tax perspective, unambiguously superior to the other funds, assuming MLPs continue to go up.

Andy: Now, Jay, that’s the case… Even if I haven’t been an investor historically, if I go buy AMZA, if I buy that ETF tomorrow, I still am receiving that kinda…

Jay: Right. Yeah. You in effect borrow that tax basis from people like me, because I’ve owned it since it was launched. And so, yeah, so it’s just an anomaly of the way ETFs work, is it, all the tax basis gets spread through the new… I mean, you create your own tax basis, but the existing tax basis, you inherit that. So, now, we have this call in a year, let’s say MLPs are way up, you know, when our stock is at $50, not $32, then that advantage will be, you know, would evaporate.

Now, and also, to be fair, you know, we run modest leverage, usually about 25% to 30%. And so, in a down market, the most likely case is either diversified portfolio of MLPs or the ETF would outperform us some, because they’re unwinding their tax liability. You know, so the advantage going up is an advantage going down, so they have a little bit less decline. Now, we’re pretty bullish about energy and MLPs being undervalued, you know, even relative to regular energy stocks, but that’s critical judgment. But most people, you know, buy investments thinking they’re gonna appreciate, so it’s probably better to buy the one that appreciates at 100 cents on the dollar versus, you know, 78 cents on the dollar.

And you can see that by looking at returns. So, if you compare us to other corporations that don’t have that tax benefit, it’s partly, you know, the differences are our selections of stocks. We do write some covered calls, but it’s small. But the biggest difference is gonna be the tax. So, the large ETF underperformed ours pretty significantly, but not because there’s any flaw other than their tax position. They do have to accrue for taxes. And they actually took a small tax write-off because of some estimation, so that hurt their NAV as well. But we don’t have a problem, because all of our taxes are not liabilities but assets, and they’re fully reserved for. So even if we change it a little bit, they’re, just, the reserve offsets that.

So, it’s all complicated, but obviously you’re not gonna get a great tax deferral, you know, situation where you can get 8% tax-deferred unless you’re willing to undertake some complexity.

Andy: Understood. Yeah. Well, it sounds to me like this ETF offers, you know, diversification in a very, you know, efficient and cost-efficient way to the MLP asset class. And I think that’s what a lot of exchange-traded fund investors are looking for is that, you know, efficient, diversified way to access an asset class. And you and I were talking… So, we talked a lot about MLPs, and thank you, you know, for kinda giving us that, you know, summary of their advantages and kinda how they could be accessed with ETFs. But we were talking before we were recording about another almost adjacent sector, not quite adjacent, but, you know, it’s interesting because we’re doing this whole series on alternative ETFs and liquid alts, and the very first episode of the series, I was talking with Daniil Shapiro about, you know, what is an alternative investment, you know. And it’s kind of a complex question, but that brings me to preferred stocks and your next ETF that I wanted to ask about.

So, this is PFFR, the InfraCap REIT Preferred ETF. Now, you know, we were talking, and, you know, you believe that preferred stocks are maybe…maybe you would include them in alternative investments, or they’re at least sort of adjacent to that space. So, could you tell us a little bit about, you know, this specific ETF, and, you know, why it might be appealing for investors right now?

Jay: Yeah, so we have two ETFs. PFFA is for active, and PFFR is for real estate. And the big ETF is PFF. And you can see our strategy, partly by the tickers, is that we’re trying to offer a better alternative to the passively-managed ETF, because we were one of the first firms to launch active ETFs, because AMZA was launched, like, nine years ago. So, we were a pioneer. So, we’re…

Andy: I’m sorry to interrupt. Which of the three preferred ETFs has the most assets under management, or which is the most popular, I guess?

Jay: Yeah, so PFFA, of our funds, is about $550 million. PFFR is relatively small right now, about $70 million. And PFF has about $13 billion of assets. That, we don’t manage that. That’s the passively-managed ETF that BlackRock manages, PFF.

Andy: I see.

Jay: So, we’re competing with PFF.

Andy: Let’s talk about PFFA then. Let’s talk about, you know, kind of the, this is the big, preferred ETF, that you all manage. So, as a high-net-worth investor, or as a wealth manager, as a family office, why would this ETF fit in my portfolio? What’s the strategy, or the benefits?

Jay: Well, to address the issue of, you know, should you consider this an alternative investment? Not really, but it has elements of being alternative. And the critical element is, it’s really a hybrid. So, we classify preferred stock as fixed income, but it’s really a hybrid between pure fixed incomes, or bonds, so, bonds are pure fixed income, and stocks. And in fact, we believe it adds alpha to portfolios to take preferreds, it doesn’t have to be our ETF, although it has a strong track record, but any preferreds, a diversified portfolio, I wouldn’t just buy one, just like I wouldn’t buy just one MLP… But a diversified portfolio, if you add it to a portfolio and take half of the capital from your fixed income, you know, bucket, and half from your equity bucket, you should get dramatically higher income, lower volatility, and lower interest rate sensitivity, and potentially higher returns. That’s unclear, depending on the environment.

Andy: So, this might be, like, instead of a 60-40 then, like a 50-30-20, with the 20 in preferred, or something like that?

Jay: Yeah. I mean, or certainly, you could stick with your allocation, but if you’re saying, “Okay, well, I gotta to sell something to move this to preferred,” you might take some ratio out of stocks and ratio out of fixed income…

Andy: I see.

Jay: …so that you don’t dramatically, so you don’t change your interest rate sensitivity that much, or your stock market sensitivity that much.

Andy: And on the risk-reward profile, generally speaking, preferred sits in between stock…

Jay: Right. So, the beta, or the volatility relative to the market, is roughly 50%. So, when you buy a preferred, if you sold all equities, then you would dramatically be lowering your exposure to the market. If you sold all fixed income, you know, like, an investment grade bond has a beta of probably 0.2, 0.3, whereas high-yield is actually pretty similar, at 0.5, so you could just take it outta high yield, and that would be a fair trade. But high-yield is really like that as well. It has certain elements of equity, because of, the betas are higher.

So, that’s what makes it a bit of an alternative. But we do think that preferreds are superior, over time, to high-yield bonds. And the reason for that, and we’re talking about just the listed $25 preferreds. So, these are sold retail, trade on the stock exchange, which you’d think is a big advantage, because you get better liquidity than trading with the street, like you’d have to with bonds. So, you get good liquidity, but more importantly, almost every issuer… And we would only invest in issuers that are public. So, the common stock’s public as well. And the reason that’s important… And we select larger-cap companies. So, what is good about that, or great about that, really, is that public companies, and I know this, having been an investment banker covering utilities, they care absolutely about their credit ratings. In other words, credit, unfortunately, for stockholders, comes before the equity holders, because they make promises to the rating agencies, to their board, to their counterparties… You know, because very few businesses don’t trade with other businesses. And if you don’t have good credit, you have to post LCs. So, these public companies are very committed to maintaining their credit ratings. Most of them are investment-grade. The preferred can be non-investment grade. So, you’re playing on the same team as management.

Andy: You’re kind of getting a free ride, I guess, if you own the preferred stock, you’re getting a free ride with the people buying those bonds, right? Because the overall corporation is being managed with an eye towards that credit rating.

Jay: That’s a great way to look at it. That’s a great way to describe it. And so, you have a company, if it is investment-grade, and most of them are… You know, keep in mind the preferred gets notched two down, so you can be triple-B. Most companies target triple-B so their preferred would be double-B or crossover-type credit. But yeah, so, our view, and it’s supported by the data, is that it’s a pretty low-risk proposition to invest in an enterprise that’s publicly-traded, with substantial equity. We don’t want publicly-traded with $100 million market cap, but billions of equity. So, they can issue equity. They can issue bonds, because they’re investment-grade. Because almost every market, even in the bad downturn, you can issue investment-grade bonds, but not necessarily of high yield. Sometimes the high-yield market shuts down.

And then you have these companies that care about the credit rating. And so, we saw this during the pandemic. Many eliminated their dividend, common dividend, or took it to a penny, because there’s some vantages to taking to a penny. But they maintained their preferred dividends. And particularly in our fund, 90% of the dividends are cumulative, so even if you don’t pay one quarter, you owe it back the next quarter, if you’re ever gonna pay another common dividend. But again, this is why it’s important to be public, because public companies care about paying dividends, not private.

And that’s contrast to, it’s not true of all high-yield bonds, but many high-yield bonds are issued by private companies controlled by private equity firms, and they get bonuses if they take cash out of the companies, and they’ll take whatever they can take out, that’s, you know, limited just by the covenants of the bonds. So, conversely, you know, we would not recommend you buy a preferred stock in private companies. That would be not a good risk-reward. But the data also supports that subjective view, in that the 30-year default rate, and this came out from Moody’s, is about 0.3% for listed $25 preferreds, over 30 years. [inaudible 00:36:07] investment-grade bonds are 0.1, and high-yield bonds are about 4%. So, your net yields…

Andy: Wow.

Jay: …are much better. If you say, “Oh, well, I don’t want this preferred. You know, it yields seven. I’d rather just buy the bonds of this… Or buy, you know, JNK or HYG.” Just keep in mind that over time, some of those bonds are likely to default. Now, the recoveries are better, to be fair. You know, you usually get 50% recovery. So, basically, you have 2% net, because the recoveries on preferreds are gonna be low. And that’s why it’s a little bit of an alternative asset class as well, because if you have a friend who’s a bankruptcy attorney and say, “Oh, I have this preferred stock ETF,” he’s probably gonna say, “Oh, well, you don’t want that, because in bankruptcy, you don’t get paid.”

But what’s missing from that analysis is what if the probability of bankruptcy is extremely low? You know, so you have to manage those two elements. How does it do in bankruptcy, and what’s the risk of bankruptcy? And since we’re selecting companies that we don’t think…you know, are extremely unlikely to go in bankruptcy, we would rather be in the preferreds and the bonds, and get paid more, versus less. But it does argue for active management, because you don’t wanna be in a situation where you have distressed preferreds that are likely to go bankrupt. That’s okay for bonds, because usually the bonds get equity in a bankruptcy.

So, it makes ’em a little bit alternative because they’re a little bit controversial, but the returns can be extremely attractive, particularly if you enter when they’re trading well below par, which they are now. Because, there’s a possibility they return to par, so you get equity upside in a fixed-income security, and substantial yield. If you just buy ’em at $25, then, you know, they can be good, but you just have to realize in a downturn, you’re gonna take some mark-to-market losses. But we’ve already, in our opinion, already taken those losses, so now it creates more upside to enter, you know, after we’ve had a very down market in both bonds and stocks.

Andy: Yeah. Preferreds, I always think they’re interesting, but they’ve always been a little bit awkward in this. You know, they don’t kinda neatly… Obviously, they don’t neatly fit in. They’re not a common stock, they’re not fixed income, but I think you did a really good job of kind of showing where they, you know, sit, maybe in a little bit of a sweet spot in that, you know, risk-reward profile, where there’s a little bit outsized reward relative to the risk, but it’s important that you understand the risks. And it’s space where, as you say, you know, maybe that active management approach can really pay off. And there’s certain, personal opinion time, you know, there’s just certain sectors, municipal bonds, there’s just little areas where I definitely prefer active management to an index because I think the value is really there.

I wanted to zoom out a little bit. So, you know, we’ve covered MLPs. We’ve covered preferred stocks. I wanted to zoom out and look at some of these larger, you know, macro trends in the alternative, let’s call the alternative ETF industry, or sort of that, the liquid alt space. So, I wanna put you on the spot and ask you, you know, Jay, what do you think are the most powerful trends in liquid alts, in MLPs and ETFs, in any of this kinda universe, that are gonna play out in the next few years?

Jay: You know, just to amplify a comment you made though, real quickly, about active management, what we didn’t cover is, you know, the disadvantage of $25 retail securities, they’re callable at par. So, not in today’s market, but it was true a couple years ago. It’s a big advantage to active management, and I would strongly recommend that, even if it’s not our ETF, because the passive funds will hold securities trading above par, callable at par. So, they don’t manage the call risk, which we do, and our active competitors do. So, it’s kind of a more objective argument, versus just, like, “Oh, I picked the best preferred.” It’s like, “No, I just avoided the one that was clearly uninvestible, because it was trading above par, callable at par.”

Andy: Sure.

Jay: So, a minor footnote. But in terms of trends on alternatives, we think that there may be more of a trend towards liquid alts, because I think that the… You know, obviously we’re a little biased, because we don’t run private equity funds, but that the private equity space almost was overallocated to a little bit, because, I mean, last year was a good example, where, okay, the equity markets were…REITs are the most extreme, but REITs are down 30%, and there’s some private funds, I won’t pick on anybody, but you could probably figure out who runs them, that were up 10% or 15%.

Andy: We all read “The Wall Street Journal.”

Jay: Yeah. So, you have to ask yourself a question, well, okay, these are pretty good managers, but did they beat the index by 45%? Probably not. So, what’s the difference? Well, they’re not fully marketing… They mark their book, but it’s not like the stock market, where there’s people trading it. So, I think that the private part of it, so, both private equity and venture capital, even in real estate funds, where kind of the value is overstated because it looks like they’re way less volatile, and they’ve produced way higher returns. But in fact, you might not have been being adequately compensated, because if you marked it to market, fully, they might be just as volatile, or should be, really. And then maybe you weren’t getting fully compensated for the fact you locked your money up for 10 years. Depends. Certain venture capital funds obviously, if they were in the right securities, could be, like, ridiculously better, but as a whole asset class. So, we think there will be more of a movement to get sort of similar volatilities but more liquidity, that would be offered by ETFs. You know, ours being sort of at the margin of that, but the liquid alts, where you actually have the liquidity, because that they trade.

Andy: Yeah, that’s an interesting prediction. I mean, it actually makes a lot of sense to me, just in a sense that, you know, broadening out private, illiquid alternatives have been sort of the belle of the ball, I guess, in the asset management world the past couple years, and really seen a lot of inflows. But as we’ve talked about in our discussion today, there’s a lot of liquid alts, or asset classes, you know, with liquid wrappers, that offer some of those same benefits, because really what investors are after, I think, is that portfolio diversification, where they can achieve, you know, the same returns, or attractive returns, while decreasing the amount of risk that they have to take on. So, I definitely agree. I think liquid alts have a place in that overall picture. And that being said, Jay, I can’t thank you enough for, you know, sharing your insights today on MLPs, on preferred ETFs, on liquid alts. Where can our audience of high-net-worth investors and advisors go to learn more about InfraCap and your family of ETFs?

Jay: Yeah. So, you can access, by the way, also our index, our inflation index, and also our market outlook that we were starting to describe, at

Andy: Okay. And I’ll be sure to link to that in our show notes, which are always available at Jay, thanks again for joining the show today.

Jay: Thanks Andy for having me on. It was great.

Andy Hagans
Andy Hagans

Andy Hagans is co-founder and CEO at AltsDb, and host of The Alternative Investment Podcast. He resides in Michigan.