Are You Along for MLPs' Wild Ride?

Passive MLP Investment Options

There are two primary investment options for those seeking a passive approach to MLPs.

An ETN is a publicly traded debt obligation of the issuer, usually a bank. Under the terms of the note, the investor receives the returns of the underlying index net of fees. Investors in ETNs are unsecured creditors of the issuing bank, exposing themselves to counter-party risk. Dividends paid are considered interest income (not return of capital). They are considered by many tax advisors as suitable investments for IRA or other tax-exempt investors as the structure blocks UBTI. ETNs offer daily liquidity and a 1099 tax form, however, investors assume counter-party risk and lose some of the return of capital tax benefits of MLP distributions.

Most MLP-focused ETFs are invested entirely in K-1-issuing MLPs and thus, do not qualify as an RIC and are subject to a fund-level tax of up to 35%. This tax has resulted in consistently large tracking error and underperformance to the Alerian MLP Index. Investors receive the benefits of a pure MLP portfolio, daily liquidity and 1099 tax reporting, but pay a high price through increased taxation at the fund level. Recently, ETFs have emerged that avoid the fund-level tax by limiting their allocation to K-1-issuing MLPs, but these products are very new, and the jury is still out.

MLP Mutual Funds

MLP closed-end funds (CEFs) have been around since 2004. Today there are approximately 32 CEFs focused on MLPs with combined market capitalization of just under $22.5 billion (and many others utilize MLPs). All the funds have chosen the option of forgoing their RIC tax status and accepting the fund-level tax. They have also generally underperformed the benchmark Alerian MLP Index since inception, in many cases by a wide margin. This is particularly noteworthy since many operate with leverage ranging between 10% and 40%, and as noted earlier, MLPs have performed quite well. Among the potential causes of the consistent underperformance are the fund-level tax drag, fund fees and expenses, and security selection. Given the consistency of the underperformance across many managers and the magnitude of the shortfall, it appears the fund-level tax drag is a significant and ongoing factor. Like other mutual fund products, CEFs issue a single Form 1099 and are not subject to UBTI.

MLP open-end mutual funds were launched in early 2010. As of Dec. 31, there were 13 dedicated MLP open-end funds with combined assets of $15.6 billion. They can be further subdivided into two broad categories: those that choose to invest 100% in K-1-issuing securities and accept the fund-level tax, and those that limit investment in K-1-issuing securities to 25% and find other securities focused on midstream energy infrastructure to complete the portfolio.

Nine of the 13 MLP-dedicated mutual funds have accepted the fund-level tax. They all provide daily liquidity, 1099 tax forms and do not generate UBTI. Since their inception in 2010, over $15 billion has been invested in these taxable MLP funds. While popular for their ease of use, they have struggled to overcome the tax burden, and most have underperformed their benchmark. Like ETFs, a corporate-level tax applied to mutual funds is a tax drag that may cause approximately 35% of a fund's gains to be lost to taxes at the mutual fund level. This corporate-level tax drag has dramatically impaired the performance of MLP-focused mutual funds that do not qualify as RICs and result in significant underperformance to the index. Investors still owe taxes on the income and capital gains distributed to them, so the tax drag results in double taxation on MLP investments. Thus, existing mutual funds that do not qualify as an RIC transform tax efficient investments in MLPs into inefficient, double-taxed investments.

Four of the 13 MLP mutual funds have limited their investment in K-1-issuing MLPs to 25% and invested the balance in other midstream energy-infrastructure companies ranging from the general partners of MLPs, C-corps that own MLPs, shipping MLPs and other midstream entities that do not issue K-1s. Some funds have expanded their investment universe beyond midstream energy infrastructure and invest in MLP debt instruments or other high-yielding equity investments like utility stocks or royalty trusts. The key to understanding the return potential of these RIC mutual funds and their tracking to the MLP Index is understanding what the other 75% of the portfolios are invested in and the objective of the funds. Certain funds may have some exposure to MLPs and midstream assets, but they also invest in utilities and other income-producing securities that are not at all related to midstream energy infrastructure. We believe the best solution involves identifying securities that mirror, closely track or even outperform MLPs. These include C-corps that own MLPs, shipping MLPs and MLP institutional shares that issue 1099s instead of K-1s. Like other mutual funds, these funds also provide daily liquidity and 1099 tax forms and do not generate UBTI.

Which MLP Option Is Best For Me?

Individual tax situations, liquidity concerns and the ability to meet investment minimums all play a role in the decision of which MLP investment option is best for each investor. Taxable investors with substantial capital to invest and the willingness to process K-1 tax reporting forms are likely to benefit from separately managed accounts or partnerships. Investors who struggle to meet the minimums (generally $250,000 and up) of SMAs and partnerships, or those who seek to avoid the tax filing issues of K-1s, should look carefully at the structure they choose. We believe MLP product offerings that avoid the additional fund-level tax and stay pure to MLPs and midstream energy infrastructure offer a better chance of delivering superior investment results.