Over the past 12 months, investment banks and asset management firms have launched 16 fund products that allocate at least 20 percent of their assets to energy-focused master limited partnerships (MLP). After this deluge of new issues, investors can now choose from an unprecedented 53 funds that offer significant exposure to publicly traded partnerships.
Investors’ fascination with this security class–a subject we tackled at length in The Appeal of Investing in MLPs–apparently transcends borders. Canada-based asset management outfit Front Street Capital’s product lineup includes Front Street MLP Income (TSX: MLP), a closed-end fund that offers exposure to a notional portfolio of MLPs that own energy infrastructure.
Fifty-three fund products is a high level of institutionalization for a universe of energy-focused MLPs that climbed to 92 names after the recent initial public offerings of USA Compression Partners LP (NYSE: USAC), CVR Refining LP (NYSE: CVRR), SunCoke Energy Partners LP (NYSE: SXCP) and New Source Energy Partners LP (NYSE: NSLP).
The proliferation and growing popularity of MLP-focused funds doesn’t necessarily mean that these products are worthwhile holdings. However, the booming population of these investment vehicles does underscore the significant fee income that investment banks and asset management outfits earn from these products.
For example, executives from Baltimore-based Legg Mason (NYSE: LM), which has launched an MLP-focused closed-end fund in each of the past three years, routinely highlight the success of these products in their analyst presentations and conference calls.
Most recently, CFO Peter Nachtwey told attendees of the Credit Suisse Financial Services Forum that the company’s ClearBridge family of MLP funds “has a strong appeal for equity investors seeking new, diversified sources of income” and emphasized that these products are “by nature, higher-fee and longer-term assets.”
Piper Jaffray (NYSE: PJC), a Minneapolis-based investment bank and asset management firm, has also sought to give investors one-stop exposure to the MLP space–and rake in fees along the way. In a conference call to discuss fourth-quarter results, CEO Andrew Scott Duff Management noted that FAMCO MLP & Energy Income (INFRX) and FAMCO MLP & Energy Infrastructure (MLPPX) were its fastest-growing products in 2012.
Although the boom in MLP-focused fund products has been a boon for investment banks and asset management firms, prospective investors must ask themselves whether the ostensibly value-added features of these investment vehicles warrant the additional fees associated with the structure. After all, investors can enjoy above-average yields and exposure to the US energy renaissance simply by holding individual MLPs.
1. Instant Diversification and Expert Management
Proponents of fund products often extol the risk-management benefits of having broad exposure to a specific assets class, emphasizing that the instant diversification provided by these investment vehicles limits the overall damage if a specific portfolio holding implodes. From a practicality standpoint, this strategy appeals to investors who’d rather not expend the time and energy to identify individual investment ideas.
However, investors who privilege outperformance over simplicity should consider the converse: A portfolio of 30 to 40 MLPs will also contain a number of underperformers that dilute your upside potential.
Although the instant diversification provided by a passively managed index fund may have produced impressive returns in the post-crisis rally that raised all ships in 2009-10, much of the easy money has been made in the MLP space. In the current environment, investors seeking sustainable yields and above-market returns should prefer a rifle (individual stocks) to a shotgun (passively managed funds).
To that end, the universe of MLP-focused funds includes a large number of actively run offerings that levy heftier fees in exchange for expert management that one would expect to outperform the Alerian MLP Index, a capitalization-weighted basket of 50 energy-focused partnerships.
Unfortunately, the performance of these funds has proved underwhelming over the past 12 months. Excluding fees, only six of the 28 actively managed funds that offer significant exposure to MLPs generated a total return that trumped the Alerian MLP Index’s roughly 14 percent gain by more than 5 percent.
Here’s a list of the top performers: First Trust Energy Infrastructure (NYSE: FIF), 19.5 percent return; Tortoise MLP & Pipeline (TORTX), 19.7 percent return; First Trust Energy Income & Growth (NYSE: FEN), 19.8 percent return; ClearBridge Energy MLP Opportunity (NYSE: EMO), 23.7 percent return; Kayne Anderson Energy Development Company (NYSE: KED) and Kayne Anderson Midstream/Energy (NYSE: KMF), 29.1 percent return.
Many of these outperformers allocated significant portions of their investable assets to security classes other than publicly traded partnerships. For example, MLPs make up about 50 percent of Kayne Anderson Midstream/Energy’s portfolio, with bonds accounting for about 16 percent and the remainder of its assets in shares general partners and other names that are structured as regular corporations. Kayne Anderson Energy Development Company also invests a significant portion of its assets in energy-focused partnerships that are privately held.
In short, the investable universe of MLPs is small relative to other sectors and industry groups, which means that many of these fund offerings–for all their claims of pursuing a unique strategy–in reality have similar portfolios that generate similar returns. In many instances, investors must ask themselves whether a fund’s performance warrants the annual fees; a manager whose fund merely hugs the Alerian MLP Index doesn’t add much value to the equation.
2. A Taxing Situation
Simplified taxes are perhaps the biggest selling point for MLP-focused funds. When tax season rolls around, MLP unitholders receive a Schedule K-1 instead of the familiar Form 1099 for regular dividends–a headache that some investors regard as an insurmountable deal-breaker.
In contrast, each of the 54 MLP-focused fund products disburses normal, qualified dividends to their shareholders and reports these payments on a Form 1099, eliminating any vexation that might arise from dealing with the Schedule K-1.
Moreover, investors can hold any of the 53 MLP-focused funds in their IRA, 401(k) or other tax-advantaged account without worrying about the unrelated business tax income (UBTI) generated by investments in individual MLPs.
Investors must ask themselves whether simplified taxes justify the fund’s expenses and the opportunity cost of missing out on the significant tax advantages that accrue from owning MLPs directly.
Similar to real estate investment trusts, MLPs pass through the majority of their profits, losses and deductions to unitholders–the MLP equivalent of shareholders–who pay personal income taxes on their share of taxable profits. In this way, MLPs investors avoid the double taxation–first at the entity level and then at the individual level–that’s part and parcel with corporate dividends.
The distributions paid by MLPs are credited directly to your brokerage account. But unlike a regular dividend, the IRS considers these distributions a return of capital that reduces your cost basis in the MLP but isn’t taxed until you sell your position.
On average, the unitholders’ share of the MLP’s taxable income comes to about 20 percent of the total distribution paid over the course of the year; this amount is taxed at the individual’s ordinary income tax rate. In other words, the taxes on about 80 percent of the distributions you receive will be deferred until you sell your position in the MLP.
The potential to defer taxation on your allocated income for years gives you more capital to put to work elsewhere. MLPs have also become popular in estate planning because the cost basis resets to the fair market value when the unitholder dies, allowing the heir to avoid taxation on previous distributions. (We discussed the intricacies of MLP taxation at length in High Yields and Low Taxes.)
Although these funds help investors avoid some of the headaches associated with figuring out tax liabilities on individual MLPs, the dividends paid by many of these offerings are subject to the double taxation that investors avoid by owning MLPs directly. Investors who opt for an MLP-focused fund also forego the opportunity to defer a portion of their tax bill indefinitely.
Elliott and Roger on Aug. 27, 2018
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