3 Ways To Profit From MLP Funds

money and investingMaster Limited Partnerships (MLPs) started to enter the limelight in 2011, but the best may be yet to come. Low interest rates are acting as a tailwind in the space, and the sector experienced its best performance in Q1/13. Hinds Howard, chief investment officer of Guzman Investment Strategies and author of the MLP HINDSight blog, tells The Energy Report about the unprecedented growth MLP funds are enjoying. He names the top performers, reveals the pros and cons of this complex investment vehicle and shares his secrets for wringing the most value out of it.

The Energy Report: Hinds, in your last interview two years ago, you explained the little-understood master limited partnership (MLP). Would you briefly recap your definition of MLPs?

Hinds Howard: MLPs are flow-through entities for tax purposes, but they trade on public exchanges. They get that flow-through tax treatment because they generate qualifying income, as the Internal Revenue Service defines it. The MLP structure is mainly applied to assets that involve energy infrastructure and transportation, and exploration and storage of natural resources. There are three ways that MLPs can produce returns for an investor: through income, through distribution growth and through change in yield.

MLPs have grown quite a bit over the years, as has the need for more infrastructure. At the same time, more and more investors are getting interested in MLPs because they pay out a lot of their cash flow. MLPs have massively outperformed the broader stock market for several years, and they provide inflation protection because of their potential to grow distributions. They’re attractive investments for individuals who want to hold them forever. However, there are some nasty tax implications when you start to sell partial or total holdings of an MLP position.

TER: How have open-end MLP mutual funds performed in the last year compared to closed-end MLPs and MLP exchange-traded funds (ETFs)?

HH: I don’t invest in MLP products. My principal investing activities are around individual MLPs. In general, it is better to own individual MLPs directly for tax purposes. Also, buying the 10 largest MLPs would probably allow an individual to track the Alerian MLP Index better than a passive ETF due to some daily corporate tax drags. But owning individual MLPs requires some level of active management and produces significant tax complexity with multiple K-1s. Hence, investors seeking passive exposure to the MLP space or seeking MLP exposure in a tax-exempt account have gravitated toward this ever-increasing pool of MLP products.

As of late August, the open-end mutual funds have averaged a 16.3% total return. The best was theOppenheimer SteelPath MLP Alpha Plus Fund (MLPNX:NASDAQ) at 23%. It employs a little bit of leverage. Eagle MLP Strategy Fund, at 20% so far this year, has the highest unleveraged performance, I believe. For closed-end MLP funds, average return has been 18.2%, with the highest being 26.3% from Kayne Anderson MLP Investment Co. (KYN:NYSE). ETFs, on average, have been around 14.7%, the highest being First Trust North American Energy Infrastructure Fund (EMLP:NYSE.A) at 16.3%.

Each of those averages is lower than the Alerian MLP Index (AMZ:NYSE), which as of late August was a 19.8% total return for the year, so open-end mutual funds have done well relative to ETFs. Closed-end MLP funds have done really well, most of that performance coming in January after the fiscal cliff debacle at the end of 2012. The Alerian MLP Index has outperformed almost everything.

TER: Some companies, like Global X Funds and Yorkville Capital Management, have multiple funds. How would an investor pick the best ETF?

HH: It really depends on what kind of MLP exposure you’re looking for. Certain ETFs follow an index; for example the Alerian MLP ETF (AMLP:NYSE) follows the Alerian MLP Index, but it’s float adjusted and market-cap weighted, so the largest MLPs represent a larger piece of that ETF. That may or may not be the best thing for an investor. If you’re looking for equal-weight exposure, some newer funds weight holdings evenly. Those are the major differences. There are not all that many MLPs to choose from. There’s theYorkville High-Income MLP ETF (YMLP:NYSE) and the Yorkville High Income Infrastructure MLP ETF (YMLI:NYSE.A), the Global X Junior MLP ETF (MLPJ:NYSEArca) and the Global X MLP & Energy Infrastructure ETF (MLPX:NYSE.A).

There are about 100 MLPs, and if you want to own an ETF that has only the midstream piece of that, you can do that through some of these MLP funds that specifically target midstream-weighted indexes. Generally those have been the best-performing assets within the MLP space. When you get a little bit further out on the risk spectrum, pay attention to the strategy and try to get the purest midstream exposure you can. You have to know what you own.

TER: What is the role of ETNs?

HH: They track the indexes the most closely, but they have their own unique issues. Like ETFs, they offer daily liquidity, very cheap fees and passive exposure to an index. But when you buy an ETN, you’re not buying ownership of an individual MLP or even an entity that owns MLPs; you’re buying a note issued by a large credit bank. So you have that credit risk of whichever bank is sponsoring the ETN, however remote that credit risk may be. Also, the quarterly dividends from ETNs are considered ordinary income for tax purposes.

The overriding theme of all these funds is there’s no perfect solution that works for everybody, and that’s why there are so many different products.

TER: Are there some specific names in the ETNs that stand out?

HH: Credit Suisse Equal Weight MLP Index ETN (MLPN:NYSE.A) is the one I would recommend for passive exposure to the MLP sector. It tracks the equal-weight Cushing 30 MLP Index.

TER: You mentioned tax surprises in MLPs. With respect to each of these different funds, what are the pros and cons in taxes, dividends, volatility and filing?

HH: Across the open-end funds, closed-end funds and ETFs, there is not a lot of difference in how they’re treated for tax purposes. The overriding theme is that there is no free lunch in the MLP space. There is no perfect vehicle that gets you MLP-like exposure without some tax drag. There is always some tradeoff, but each of these products—open-end funds, closed-end funds and ETFs—has daily liquidity. Their dividends are largely considered return of capital. So those are some of the positives. Each one of them produces a 1099 rather than a K-1. Each one blocks unrelated business taxable income, which is why you can own them in tax-exempt accounts more easily than you can own an individual MLP. But each one is usually structured as a corporation. That causes a double taxation effect that individual MLPs don’t have.

Closed-end funds have a limited amount of capital and they can’t create new units, so their market value can trade out of whack with the net asset value (NAV) of the funds themselves because there is a fixed supply of units. The closed-end and open-end funds both offer active management, but open-end funds tend to track their NAV better. ETFs are largely passive and have lower fees but they don’t track their indexes well because of the daily corporate tax drag. ETNs track their indexes closely, because they are structured to do exactly that. ETNs pay interest that tracks the distributions of the index it tracks, net of a management fee.

TER: Are institutional investors starting to discover MLP funds?

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