The MLP sector has been one of maximum pain for investors. Such long and brutal bear markets often tend to produce conditions for maximum returns for sectors. Often, not always though. We have stated our bias here previously, and the MLPs investors will be best served by sticking to quality and avoiding common shares. Preferred shares and baby bonds where feasible offer the best possible risk-adjusted returns, in our view.

But what if we are wrong? What if the sector has bottomed and the market has discounted the tremors ahead? In that case, which is the best way to play the sector? We recently highlighted two funds in this space (see here and here), and neither of them come close to the one we are about to talk about today.

The First Trust MLP & Energy Income Fund (FEI) is one of the best-performing MLP funds and is shockingly ignored. This “not-so-well-known” closed-end fund invests in the MLP sector using one of our favorite strategies. It uses covered calls to reduce volatility and enhance returns. We have always deployed options in our own trades, and they are the single best “free” source of alpha there is. They act to reduce volatility and also help investors buy low and sell high (not a marijuana reference).

The Fund

FEI has managed to do something rather extraordinary from the point of view of the common investor. It has taken leverage, within a sector that has gotten decimated, and managed to outperform non-leveraged passive ETFs like ALPS Alerian MLP ETF (AMLP).

ChartData by YCharts

That is a truly outstanding achievement from the point of view of the common investor, but one we predicted as the fund was busy selling covered calls in a thoughtful manner. FEI delivered -47.79% over the last five years, beating the ALPS Alerian MLP ETF, which came in at -52.39%. It did better than the closed-end funds we track. Kayne Anderson MLP/Midstream Investment Company (KYN), shown here as an example, delivered a rather shocking -70.30%. The InfraCap MLP ETF (AMZA), which is an actively managed ETF employing high amounts of leverage, delivered -74.33%.

The Portfolio

FEI’s top holdings include some rather uncommon names:

Source: First Trust

For example, you would be hard-pressed to find TC Pipelines (TCP) as a top 10 holding in any other MLP fund. TC Energy Corp. (TRP) is also a rare find. The Canadian pipeline company has outperformed its US peers by a wide margin. Interestingly, FEI holds multiple non-MLP holdings in its fund, including Enbridge Inc. (ENB) and AltaGas Ltd. (OTCPK:ATGFF). FEI has also underweighted Energy Transfer (ET) rather substantially versus the MLP index. This move does look rather brilliant, as EPD, ENB and TRP have done much better than ET’s total returns.

ChartData by YCharts

FEI has also extended its reach outside the MLP Universe and holds many utilities. This weighting has increased over time, and more than one-third of the fund’s assets are now in this sector.

Source: First Trust

So, FEI has beaten the MLP index by investing in stocks that do not fit the traditional MLP definition. We are sure existing investors appreciate this deviation.

Options Usage

FEI writes covered calls, but unfortunately, the amounts are extremely modest for our taste.

Source: First Trust

Total premiums received at the time of last update were very small. While they do add some alpha, they are radically different than our strategy, which employs it on 70-100% of total holdings. Additionally, FEI sticks to writing covered calls on what it owns, and there are no speculative options sold (naked calls).

Distribution Sustainability

FEI’s 11.24% distributions appear about average for the sector. FEI did cut its distributions after the March selloff, but that was to be expected.

Source: First Trust

FEI also has a very heavy utility weighting, and that sector is producing closer to 4% rather than double-digit yields that are now common in the MLP space. Our rough estimate is that the FEI portfolio generates about 6% yield on NAV on a current run rate basis. While that is lower than the payout, three factors make us think that the current level is sustainable.

Firstly, FEI trades at a solid discount to NAV, so yield on market price is higher than yield on NAV.

ChartData by YCharts

FEI also generates option income, and that should add 2-3% yield annually at the minimum. Finally, FEI’s modest use of leverage also enhances overall yield. FEI thus enjoys the lowest danger level rating on our proprietary Kenny Loggins Scale, even in this climate.

A low danger rating implies a less than 15% probability of a dividend cut in the next 12 months.

Conclusion

FEI is an interesting way to play the MLP space. If the sector has bottomed, the fund could generate 12%-15% total returns going forward. The large discount to NAV could also close, and that could add more alpha. FEI recently started repurchasing its own shares, and that could also add some additional gains. The large utility holdings may detract if a secular bull in MLPs and Energy has begun. But the same utility sector holding will likely make the distributions more sustainable if we have more pain to come in the MLP space. FEI remains our “top pick” in the CEF space for this sector. For our portfolios though, we are sticking to preferred shares in the MLP space and generating more yield via safer cash secured puts and covered calls.

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Are you looking for Real Yields which reduce portfolio volatility?  

Conservative Income Portfolio targets the best value stocks with the highest margins of safety. The volatility of these investments is further lowered using the best priced options. Our Cash Secured Put and Covered Call Portfolios are designed to reduce volatility while generating 7-9% yields. We focus on being the house and take the opposite side of the gambler. 

Learn more about our method and why it might be right for your portfolio. tets

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long positions in ENB preferred shares.

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