July 1, 2013

Some Clarity on Energy MLP-Related Funds

by Ed Moisson.

Despite energy master limited partnerships’ (MLPs’) subpar showing for 2012, investors may be eyeballing the historically strong yields and potential tax benefits of MLPs.

REUTERS/Laszlo Balogh

REUTERS/Laszlo Balogh

Why MLPs? To foster development in vital infrastructure assets the U.S. Congress passed legislation in 1986 to exempt MLPs from paying federal and sometimes state income taxes as long as at least 90% of a business’s revenue is being generated from certain qualifying activities. The majority of energy MLPs operate in slow-growth but capital-intensive sectors of the energy industry, such as pipelines and storage terminals—often referred to as the “midstream functions” of the oil and gas industry—processing, transporting, and storing crude oil, natural gas, and petrochemicals.

Energy MLPs have become a popular choice for many investors, not only because of the favorable tax treatment and high yields but also because of their stability. Unlike oil and gas producers, which are subject to price fluctuations in the underlying commodities, many of the larger energy MLPs function as tollgates for the products they transport or store, basing their revenues on the volumes running through their systems; they are generally well compensated for their services. Since many of these products and services are so capital intensive, competition is often very limited in most regions, and the barriers to entry are fairly steep. In addition, these products and services usually don’t require a lot of ongoing capital expenditure other than routine maintenance.

As a result it is not surprising that many MLPs produce stable and quasi-predictable cash flows in both up and down markets.  Since most energy MLPs are considered slow-growth companies, investors shouldn’t expect long-term capital appreciation; instead, just as other mature businesses do, MLPs generally pay out handsome dividends to their unitholders (MLPs’ parlance for shareholders). Caveat emptor! Like other yield producing securities, MLPs can be very sensitive to interest rate changes. Because MLPs are pass-through entities, meaning they don’t pay taxes at the corporate level as long as they divvy up the profits among their unitholders, their dividends are generally more robust than those found in other corporate structures. Unitholders of individual MLPs must file a special tax form (a K-1) every year, and the tax rules are quite complex.

Along with a need for portfolio diversification, these complex tax rules are the catalyst for the creation of pooled investment products in this space. (It’s definitely worth mentioning that some of the smaller recently created MLPs are exploration and production companies that are more prone to commodity price swings, which should be considered when evaluating these offerings. While they might carry more upside potential and diversification, they also carry the risk of distribution cuts.) The fund industry offers several ways retail investors can participate in the renaissance of the energy industry in the U.S., but pooled investment vehicles offer their own set of trials and tribulations. Under the American Jobs Creation Act of 2004, Congress restricted regulated investment companies (RICs) from investing more than 25% of their assets in MLP securities, leaving funds with two choices: (1) Maintain their RIC status and enjoy the pass-through nature of funds, but being able to invest only up to 25% in MLPs. The other portion can be invested in energy-related products to avoid being taxed at the fund level. Or, (2) funds can structure themselves as C-corporations and suffer double taxation. They pay taxes on distributions at the corporate level (often not a significant amount, because usually between 70% and 100% of MLP distributions are returns of capital) and pass reduced distributions to their shareholders, which are taxed again at the fund-shareholder level. As with any asset class a diversified investment pool is probably the best approach to use. However, choosing between closed-end funds (CEFs), exchange-traded products (ETPs), and open-end funds committed to this market segment can be a daunting task. There are pros and cons to all three vehicles.

CEFs were the first pooled investment vehicle to attack the issue, initially structuring themselves as C-corporations; however, they often suffered from larger-than-normal discounts. Lipper currently tracks 25 MLP CEFs. Nine of the 25 CEFs function as RICs; thus, they do not invest over 25% in MLPs. The remaining 16 are structured as C-corporations; while they suffer double taxation, they have full exposure to energy MLPs. As of March 31, 2013, MLP-related CEFs had approximately $16.5 billion in total net assets. For the year-to-date period ended April 19, 2013, the average CEF structured as a C-corporation returned 17.42%, while its RIC-related cousin posted a 15.14% return. At the three-year mark the discrepancies are slightly wider, with the C-corp CEFs returning 18.60% and the RIC CEFs returning 14.48%. Both structures are outpacing the Dow Jones Industrial Daily Reinvested Average Total Return Index and the S&P 500 Daily Reinvested Total Return Index, which returned 11.74% and 9.72%, respectively, for the year-to-date period and 12.44% and 11.46% average annualized returns for the three-year period. Interestingly, despite suffering the impacts of double taxation, the C-corp CEFs had an annualized distribution rate of 6.72% on average, while their RIC-related cohorts boasted a 5.59% annualized distribution rate as of March 31, 2013. (When you are doing CEF-related research, keep in mind that many CEFs use leverage, which can boost returns during good times but can also exacerbate losses during declines. Because CEFs often trade at premiums or discounts to their net asset value [NAV], there are some unique opportunities to using CEFs for your MLP exposure. In most cases CEF MLP investors will receive a 1099-DIV tax form instead of a K-1, making the tax portion of the puzzle easier to figure out. At the same time the tax-deferred quality of MLP distributions—typically a return of capital—is maintained.)

The number of MLP-focused ETPs (exchange-traded funds [ETFs] and exchange-traded notes [ETNs]) has risen over the last few years. Since 2009 fund shops have created 17 new product offerings in this space, including the four new funds brought to market so far in 2013, bringing the total net assets invested in MLP ETPs to slightly under $13.6 billion. MLP ETNs have different tax treatments than do MLP ETFs. As you might expect, the ETFs are structured as C-corps or RICs, while their ETN counterparts are corporate debt obligations that use total return swaps to match their related index. So, while the ETFs generally do a better job of passing through the quality of MLP distributions, the ETNs better replicate the total return of the underlying partnerships found in the index. The year-to-date returns through April 19, 2013, show the impact double taxation has on C-corp ETFs (+11.46%) and the lower return of RIC-structured ETFs (+13.42%) versus their MLP ETNs’ (+19.64%). Granted, some of the return differences are obviously inherent in the different indices, but nonetheless investors still need to properly evaluate the different structures within this space along with the tax implications. As of this writing there was only one MLP ETF that was structured as a RIC, maintaining its tax-pass-through benefit: First Trust North American Energy Infrastructure (EMLP).

Obviously, we can’t leave out the old tried-and-true vehicle of the funds industry—traditional mutual funds. Because of the need to choose between being a C-corp or maintaining their RIC status, mutual funds have been slow to move into this space; the first group of equity offerings started in 2010. Today Lipper counts 19 unique funds comprising 55 different share classes that offer active management in this space. Eleven of the 19 unique funds are structured as C-corps, while the remainder follow the traditional RIC requirements. The group manages over $7.6 billion of MLP-related assets. Given the recent strong showing of individual MLPs, it is not surprising to see the more focused C-corp-structured open-end funds (+12.17% on average) outpace their RIC-structured brethren (+10.84%).

While an individual energy MLP may provide better returns and tax benefits, energy MLP-related funds can offer greater convenience, diversification, and tax-filing ease.

* This article originally appeared in the June 2013 issue of On Wall Street Magazine

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