CA - Sell FEN And Buy FEI

Summary

• Three First Trust Funds are extremely similar and provide exposure to almost the same underlying holdings.
• We examine FEN and FEI today and give you our 2023 outlook.
• We look back at our call at the beginning of 2022 and tell you why it gave you so much excess in returns over buy and hold.

First Trust MLP & Energy Income Fund ( FEI ) is a fund we last covered exactly two years back .

To say that the fund has performed well versus the benchmarks would be a massive understatement.

While the midstream sector has been great for income in 2022, capital returns have been the domain of the Exploration and Production sector. You can see that in the case of FEI as well, where the price has gone sideways for most of 2022. We look at this fund again today and benchmark it against another fund from the same family, First Trust Energy Income & Growth Fund ( FEN ).

The Fund Basics

FEI focuses on the large midstream companies with Enterprise Products Partners L.P. ( EPD ), Magellan Midstream Partners, L.P. ( MMP ), and Energy Transfer LP ( ET ) forming more than a quarter of the fund's holdings. The top holdings make up more than 50% of the fund.

While those holdings make it appear that the fund is a US midstream proxy, that is definitely not accurate. It has a lot of holdings outside that, including upstream plays like BP p.l.c. ADR ( BP ) and Shell plc ADR ( SHEL ). The fund also is happy to hold non-energy midstream companies from up north including Enbridge Inc. ( ENB ), TC Energy Corporation ( TRP ), and Keyera Corp. ( KEYUF ). While all these did not make the top 10, FEI holds sizeable stakes in them.

One of the issues of the upstream and midstream sectors is that they come with a lot of volatility. This plagues most funds in this area. FEI tries to dampen this in two ways. The first is that it uses utilities for a portion of its portfolio. Based on the last released report, 30% of the fund's assets were in this sector.

While this fund will never become a Reaves Utility Income Fund ( UTG ), the large utility holdings do put a sizeable dent in the volatility. The second volatility dampening modality comes via covered calls. While the fund does use these, historically the amounts have been quite modest.

These won't make or break the fund but definitely lower the volatility and create extra income harvesting avenues.

Macro Call

We remain positive on midstream companies and think FEI's emphasis on large quality holdings will continue to play well into 2023. We also like the fact that it has added some exceptionally undervalued upstream exposure. On the utility front, we are less sanguine but think it fits in the overall picture. FEI should definitely be a better bet versus a pure utility-focused fund like UTG.

FEN

FEN is another fund from the same family and as of November 30, 2022, these were its top 10 holdings.

If that gave you a Deja vu, you are not alone. The holdings have ranged from virtually identical to identical for these funds. One key difference is that these funds were started at different times. FEN was started in 2004 while FEI only came into existence in 2012. This likely created some differences in their longer-term return profiles, likely from a tax management standpoint. But over the last few years, they have become more and more similar and legacy differences are fading into the background. Here is the total return on NAV over the last three years to illustrate our point. Watch how their NAVs (not prices) almost move tick for tick.

Of course, some differences can creep up, but we give this coin toss chance of going either way. Ok, so both funds are identical. Why bring this up though is the question you may have on your mind.

Price Is What You Pay, Value Is What You Get

The answer to that is how these funds are priced. In a world where alpha is extremely hard to generate, the premium discount factor of identical or virtually identical funds is one of the easiest and most reliable sources of alpha. Here you can see that FEN is trading at a 6.45% discount to NAV, while FEI is trading at an almost 14% discount to NAV.

Assuming this gap closes as it has in the past, you get 7.5% of extra alpha just from being long the right fund. In this case, this is obviously FEI.

A Look At A Similar Call From A Year Back

FEN has recently been the most expensive of the First Trust midstream closed end funds. We are not just talking in relation to FEI, but even in relation to First Trust New Opportunities MLP & Energy Fund ( FPL ). In fact, at the beginning of 2022, we saw the rather irrational pricing and suggested investors take advantage of wild price chasing by making a switch.

The logic was similar, the spread between the premiums of the two funds had reached a historic high.

The result?

If you ignored the opportunity and stuck with FEN, you made a total return of 2.48%. If you switched, you made 16.16%.

The case to switch to FEI is in essence a continuation of that call as all three funds are virtually identical and should trade at the same premium/discount to NAV at any given point. We think selling FEN and moving to FEI (or even FPL) makes sense for 2023.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. We strongly recommend you have a Merry Christmas and a Happy New Year.

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