Closed-end funds specializing in master limited partnerships offer a disarmingly simple value proposition: the same great businesses and the same relatively rich yields, with much more diversification and none of the tax-filing hassles.

Yet each of these selling points comes with caveats.

Start with portfolio composition. An individual investor can own nothing but MLPs and expect not to owe immediate taxes on the bulk of the income from that portfolio. The investor may face a delayed tax hit when an MLP is sold, or maybe not, since the Grim Reaper will at least spare one’s heirs the hurt of depreciation recapture.

The tax advantages are less accessible to closed-end funds, which qualify for the same pass-through treatment as other limited partners only if publicly traded partnerships make up no more than a quarter of their portfolio. More than that, and the fund must pay corporate income tax. Some closed-end funds have pushed the envelope by investing in subsidiaries that can lift a fund’s indirect MLP exposure up to 50 percent. But the bottom line is that MLPs were set up to encourage direct investment in the partnerships, and the tax code is unfriendly to financial intermediaries hoping to cash in on the same perks.

The choice between losing either some of the tax efficiency of MLPs or some of their yield drives almost all closed-end funds to use leverage to compensate. Given the strong historical performance of MLPs, this additional leverage has caused few problems to this point.  But the use of debt to buy additional assets does heighten the risk, for the sake of merely matching the direct investor’s unleveraged performance.

The diversification benefit of closed-end funds is real, but of dubious value to investors who own a variety of MLPs directly, which I assume describes most MLP Profits subscribers. Gaining exposure to the entire MLP sector with the purchase of a single closed-end fund is convenient. But adding one to a portfolio that already includes plenty of MLPs provides much less incremental diversification, and won’t cut down on tax filing hassles.

In fact, closed-end funds have its own tax complexities, one of which is figuring out whether future distributions are likely to be classified as ordinary income, qualifying dividends, short-term capital gains, long-term capital gains, a return of capital or some combination of the above.

Plus, MLP funds carry some of the financial industry’s highest fees and expense ratios. Our mission here at MLP Profits is to help you avoid the cost and the tax leakage of such funds with guidance on assembling a savvy MLP portfolio directly.

Still, the temptation to subcontract at least some of the investing spade  work is strong, and the lure of replacing multiple K-1 partnership income forms with a single, simpler miscellaneous income Form 1099 is nearly irresistible.

Not to mention that many closed-end funds trade at a discount to their net asset value — surely some of the ones that dabble in MLPs might be worth a shot at 90 cents on the dollar?

Actually, no MLP fund currently offers a NAV discount that wide, and a few even fetch a premium. But a few of the discounts are sufficient to offset the cost of these funds for a year or three. For those determined to stick a diversified 6 percent yield in an IRA, they’re far from ideal but not the worst idea either.

The goal of the brief survey that follows is to identify the more promising of these investment vehicles, while steering clear of the accidents waiting to happen.


Source: MLPdata.com

Pricey Cushing Courting Risk

The highest-yielding MLP closed-end fund, the Cushing MLP Total Return Fund (NYSE: SRV), unfortunately looks like one of the latter. Its distribution rate is 9.9 percent, but this yield is unlikely to prove sustainable. SRV’s distribution coverage ratio, adjusted for advisory fees and operating expenses, has languished well below 1 for the last two years. In the year ended Nov. 30, it paid out a dollar in investor distributions for every 80 cents in current income earned, net of expenses and costs.

So why is this fund trading at a 26 percent premium to net asset value? Likely because it retained, as of November, $63.7 million in capital loss carryforwards available to offset future taxable income. Yet the bulk of that tax asset will expire in November of this year, and at that point SRV’s tax bills are likely to increase significantly.

To sustain the high distribution rate, Cushing’s portfolio managers have stuffed the portfolio with many high-yielding and correspondingly high-risk partnerships. Notably, shipping and upstream energy production plays accounted for nearly 27 percent of the total as of March 31.

That leveraged and relatively risky portfolio has returned nearly 16 percent year-to-date, versus an 11 percent total return for the Alerian MLP Index. Meanwhile, advisory fees and expenses for the last full year amounted to 2.2 percent of the net asset value at year-end. The performance edge and premium valuation could evaporate in a flash during the next industry downturn, causing yield chasers to exit all at once. As recently as 2011 and 2012 SRV’s performance lagged the MLP sector. This is one to avoid.

Kayne Is Able

The only other closed-end MLP fund selling at a double-digit premium to its NAV is Kayne Anderson Energy Development Company (NYSE: KED), priced at 11 percent above its NAV, which was last reported at the end of the first quarter on Feb. 28. The premium to current NAV is likely to prove considerably lower.

KED’s main attraction is not its run-of-the-MLP-mill 5.5 percent distribution yield, but rather the juicy 25 percent capital gain it’s notched year-to-date, capping a three-year period of impressive outperformance:

Source: Kayne Anderson presentation

Kayne Anderson’s edge comes from its status as the pre-eminent MLP private equity shop, and the astute non-public investments the fund has made as a result.

Its investment in Plains All American GP, the general partner of Plains All American Pipeline (NYSE: PAA), has more than quadrupled in less than four years after the GP went public last year as Plains GP Holdings (NYSE: PAGP).

Another of KED’s nonpublic investments, Direct Fuel Partners, was merged last year into Emerge Energy Services (NYSE: EMES), a fracking sand supplier whose unit price has increased six-fold since an IPO in May 2013. Emerge was still by far KED’s largest holding at the end of February, accounting for 9.3 percent of the portfolio. Its price has more than doubled since.

Success often doesn’t come cheap, and in KED’s case it costs a hefty 3.6 percent of assets annually. But the fund has also become a victim of its own success, acknowledging in the last annual report that it’s “finding it more challenging to invest in private MLPs that provide appropriate rates of return” given the competition from private equity, acquisitive MLPs and an eager public willing to finance new ventures via IPOs. That means fewer future home runs for Kayne; KED has only one private investment left in the portfolio.

Also sitting in the portfolio and weighing on the NAV is $82.4 million in deferred tax liability on gains that have yet to be realized. If the tide were to turn and KED were to become inclined to sell more of its winners, some of that overhang could turn into a very current drain on income.

Tortoise Plays It Safer

At the other end of the valuation spectrum, the Tortoise Pipeline & Energy Fund (NYSE: TTP) is trading at a 9.7 percent discount to its recent NAV,  while currently yielding 5 percent.

Source: CEFconnect.com

TTP is set up as a regulated investment company, so is not taxed on its income. The tradeoff is that its direct investments in MLPs can’t exceed 25 percent of the portfolio. Making a virtue of that necessity, the fund has focused on the corporate parents of midstream MLPs, including many of the same ones we’ve been recommending with excellent results for the past year.  Williams (NYSE: WMB) is the top holding at 9.6 percent of the portfolio, followed by Spectra Energy (NYSE: SE) and ONEOK (NYSE: OKE). NiSource (NYSE: NI) and  Targa Resources (NYSE: TRGP) round out the top five.

To compensate up for the lower yields many of its corporate investments offer relative to MLPs, TTP writes near-term, modestly out-of-the-money covered calls on oil and gas drillers and, like all MLP closed-end funds, employs leverage as well. Roughly half of the most recent distribution was classified as ordinary income, and the rest as a return of capital.

The fund’s sponsor is a pioneer in MLP asset management, and second in the scale of such assets only to Kayne Anderson. The five members of the investment committee have an average of 28 years of experience, and the six analysts average 14 years. Operating cost including advisory fees were a relatively modest 1.3 percent of net assets last year, while debt interest bumped up the total expense ratio to not quite 2.2 percent.

While the distribution yield is just about half of that from the Cushing MLP Total Return Fund, Tortoise Pipeline & Energy provides much better tax efficiency, less risk and more attractive long-term fundamentals.

The Tortoise has recently had most hares eating its dust with a return of nearly 19 percent year-to-date. One of these days the share price could certainly play catch up.

Bargain Bin Opportunity

Also on sale is the Cohen & Steers MLP Income and Energy Opportunity Fund (NYSE: MIE), trading at a 9.6 percent discount to its net asset value. The NAV has increased nearly 16 percent year-to-date, outpacing the 12 percent increase in the share price. 

Source: CEFconnect.com

MIE is another tax-efficient fund that owes no income tax on its income, and can only invest 25 percent of its assets into partnerships directly. But the fund has invested another quarter of its portfolio in a subsidiary that in turn invests all of its assets in MLPs, giving MIE an aggregate exposure of 50 percent to the higher-yielding partnerships. The fund asserts that this maneuver is legal and defensible, but acknowledges the risk that the Internal Revenue Service might disagree.

Although the fund only launched in March of 2013 and its lack of track record is likely contributing to the current discount, the managers are experienced and accomplished, with more than 15 years each of relevant experience and more than a decade at Cohen & Steers, where they’ve overseen investments in infrastructure assets.

Low-cost fixed debt finances 30 percent of the fund’s assets at an annual cost of less than 0.5 percent of total assets, and the remaining expenses equal less than 1.5 percent of total assets, or 2.5 percent of the assets backed by common shares.    

Top holdings as of March 31 included Enterprise Products Partners (NYSE: EPD) at 7 percent of the portfolio, Kinder Morgan Management (NYSE: KMR) at 5.9 percent and Buckeye Partners (NYSE: BPL) at 5.2 percent.

Level quarterly distributions currently represent an annual yield of 6.3 percent. During the fund’s first eight months of operations through Nov. 30, 86 percent of its distributions were classified as return of capital, and the rest as ordinary income.

MIE is an “opt-out” fund, meaning distributions will be automatically reinvested into additional fund shares unless a shareholder contacts plan agent Computershare or their broker to request cash payments. This is a common feature of closed-end funds and is used as well by all others mentioned in this story.