With the initial public offering of Yorkville High Income MLP (NYSE: MLP) on March 13, investors can now choose from 41 fund products–20 closed-end funds, 10 exchange-traded products and 11 mutual funds–that focus on master limited partnerships (MLP).

Of these offerings, 29 launched within the past two years, with 11 new mutual funds hitting the market, nine closed-end funds (CEF), seven exchange-traded notes (ETN) and two exchange-traded funds (ETF). To get a sense of how rapidly this growth has occurred, check out this graph tracking the monthly total assets of ETNs, ETFs and mutual funds that offer one-stop exposure to energy-focused MLPs.

Source: Bloomberg, Morningstar, MLP Profits

The proliferation of fund products that provide targeted exposure to energy-related MLPs in part reflects the fundamentals and market conditions that make these securities appealing to investors.

Although investors should never regard past results as a predictor of future performance, many of the tailwinds that have enabled the Alerian MLP Index to outperform the S&P 500 by almost 80 percent over the past three years remain in place.

For one, MLPs that own and operate midstream infrastructure for processing and transporting oil, natural gas and natural gas liquids (NGL) stand to benefit over the next several years from rising demand for takeaway capacity in the nation’s prolific shale oil and gas plays.

Surging activity in the Bakken Shale in North Dakota, the Eagle Ford Shale in South Texas and other plays has enabled the US to grow it annual oil output for the first time in decades.


Source: Energy Information Administration

Even more impressive, this increase in overall oil volumes has occurred despite a sharp decline in production offshore Alaska and in the Gulf of Mexico.

Source: Energy Information Administration

Meanwhile, frenzied drilling in the nation’s shale plays enabled the US to surpass Russia as the world’s leading producer of natural gas and has dramatically depressed gas prices in the closed North American market. Despite gas prices that continue to hover near record lows, US output has continued to grow. Exploration and production firms have shifted their emphasis from dry-gas fields to fields such as the Marcellus Shale and Eagle Ford Shale that also produce large volumes of higher-value NGLs that improve wellhead economics.

Source: Energy Information Administration

This upsurge in onshore oil and gas output has occurred in many regions that lack legacy takeaway and processing capacity, while even the Permian Basin in west Texas–an area that’s produced oil since the 1920s–requires additional infrastructure to handle growing volumes.

The Interstate Natural Gas Association of America (INGAA) estimates that the US and Canada will need to spend $83.8 billion to build and expand enough midstream infrastructure to support the surge in onshore production. Although a trade organization that represents pipeline owners produced this report, many of the pricing and production assumptions underlying the INGAA’s estimates appear reasonable.

Demand for these midstream assets will be met by MLPs, setting the stage for the best-positioned names to grow their cash flow and quarterly distributions to unitholders. Rising cash flow and quarterly payouts inevitably add up to rising stock prices.

MLPs also continue to reap the rewards of an extraordinarily low cost of capital, the product of the Federal Reserve’s accommodative monetary policy. Because MLPs are pass-through entities that disburse the majority of their cash flow to their investors, publicly traded partnerships rely on the debt and equity markets to fund acquisitions and organic growth projects.

Able to raise inexpensive debt and equity capital, members of the Alerian MLP Index have stepped up mergers and acquisitions activity dramatically, announcing $89.9 billion worth of deals since 2010. Pipeline assets have been involved in $27.2 billion worth of transactions, with natural gas distribution infrastructure accounting for $16 billion in deal flow and oil and gas fields accounting for $15.5 billion. 

Source: Bloomberg 

The happy confluence of ready access to cheap capital, higher oil prices and robust demand for midstream infrastructure to support frenzied drilling in the nation’s shale plays should ensure that the Alerian MLP Index continues its recent track record of distribution growth.

Source: Bloomberg

In addition to these tailwinds, investor psychology and demographics should increase investment in the group. Despite the Alerian MLP Index’s recent rally, the benchmark still offers superior yields to an overbought bond market and traditional income-oriented securities such as real estate investment trusts.

Many income-seeking investors also remain scarred by the stock market implosion that accompanied the global credit crunch and Great Recession, a period that reminded investors of the risk involved in investing in higher-yielding fare. Few will forget the panic that ensued when corporate titans such as General Electric (NYSE: GE) and Bank of America Corp (NYSE: BAC) were forced to slash their dividends after the credit bubble burst.

In contrast, many energy-related MLPs managed to maintain their distributions throughout this turbulent period, overcoming frozen capital markets and plummeting oil and gas prices. MLPs that own midstream assets such as pipelines proved the most resilient; these names tend to garner much of their cash flow from fees and are relatively insulated from fluctuations in commodity prices.

At the same time, uncertainty surrounding the EU sovereign-debt crisis and global economic growth should ensure that volatility once again rules the stock market through at least 2012. With shell-shocked investors seeking reliable income and growing dividends to offset losses incurred by panicked selling and a flat stock market, expect inflows to the MLP sector to continue apace.

Besides investor psychology, demographic trends also bode well for energy-related MLPs. The US Census Bureau estimates that the number of elderly American will increase by 36 percent in 2020 and 79 percent in 2030. The sustainable, tax-advantaged yields offered by MLPs hold a great deal of appeal for investors seeking to convert accumulated savings into a lifelong income stream.

Not surprisingly, investment banks and asset management firms have been quick to capitalize on rising demand for MLPs by rolling out a slew of fee-generating funds that offer one-stop exposure to this asset class.

But investors shouldn’t assume that the proliferation and growing popularity of these investment vehicles mean that they’re worthwhile holdings; the fee income that asset management from closed-end funds and exchange-traded products is considerable.

Much of the easy money has been made in the wake of the financial crisis and market meltdown, though asset managers and investment banks continue to rake in the fees by launching new investment products. But in the New Normal, stock selection and a focus on valuations will be essential to outperforming the broader market and the Alerian MLP Index.

Many MLP-focused funds offer exposure to the high-quality names that appear in our model Portfolios, but investors should be aware that these investment vehicles invariably include marginal fare that detracts from overall performance.

Proponents of fund products often extol the risk-management benefits of having broad exposure to a specific asset class. But the “instant diversification” that blunts the impact if an individual stock tanks also dilutes these funds’ upside potential.

Recent results suggest that investors seeking sustainable yields and above-market returns should rely on a rifle (stock-picking) rather than a shotgun (a fund). Excluding fees, only six of the 41 MLP-focused funds currently on the market have outperformed the Alerian MLP Index over the past 12 months, while only 10 generated returns that bested the 8.6 percent gain posted by the S&P 500.

Investors who own one of these funds and units of blue-chip names such as Enterprise Products Partners LP (NYSE: EPD), Kinder Morgan Energy Partners LP (NYSE: KMP) and Plains All American Pipeline LP (NYSE: PAA) should be forewarned that these stocks also figure prominently in many fund portfolios. 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.

The funds pushed by the various investment houses eliminate some of the headaches with figuring out tax liabilities on individual MLPs–investors receive a single Form 1099 rather than a slew of Form K-1s. But many of these funds expose investors to the double taxation that individual holdings avoid. The remainder of this section will focus on the advantages and drawbacks of each structure.

1. Closed-End Funds

Source: Bloomberg, Morningstar

Whereas capital flows into a mutual fund when investors buy shares, CEFs trade on an exchange and don’t issue or redeem shares on a daily basis. Accordingly, CEFs typically trade at a premium or discount to their net asset value of the fund’s underlying holdings. A CEF can trade above or below its net asset value for an extended period; investors need to look for a catalyst that will drive a move to the upside or downside.

These funds can also take on leverage to juice portfolio returns and boost the fund’s yield. However, investors should be aware that a meaningful decline in a leveraged CEF’s net asset value could force management to sell assets to comply with regulations and debt covenants.

For many years, CEFs were the only fund product that offered concentrated exposure to MLPs, in part because the structure’s relatively stable capital base enabled managers to invest in securities with less liquidity. Although institutional investors have added to their MLP exposure in recent years, these stocks are owned primarily by individual investors; when the first MLP-focused CEFs launched eight years ago, liquidity constraints were more pronounced.

Today, investors can choose from 20 closed-end funds, though the relatively small investable universe of MLPs ensures that the portfolios of these funds often overlap considerably. For example, the number of CEFs that allocate at least 15 percent of their investable assets to the three largest MLPs is astounding.

The appeal of these funds is simple: Investors delegate the challenge of picking individual stocks and constructing a portfolio to a professional fund manager and receive a single Form 1099 rather than a Form K-1 from each MLP in which they’ve invested. As institutional investors, closed-end funds also have the opportunity to purchase units directly–and usually at a discount–during initial public offerings and secondary issues.

2. Exchange-Traded Funds & Exchange-Traded Notes

Source: Bloomberg, Morningstar

Although ETFs and ETNs also trade on stocks exchanges, the resemblance to CEFs stops there.

Whereas a CEF increases its total assets through appreciation, leverage or secondary issues, an ETF’s authorized participant–a designated institutional investor that creates or redeems shares–ensures that supply matches demand and that the fund’s market value corresponds to its net asset value.

This structure has grown increasingly popular among investment banks and asset managers, which, in their role as authorized participants, collect the difference between the total value of the fund’s underlying assets and its market price.

On the other hand, ETNs represent a bank issuer’s IOU that promises to track a specific index. This structure entails some risk–if the issuing bank goes bankrupt, investors will have to queue up with other creditors to recover their money–but also are more efficient because they’re taxed like stocks.

Although we prefer investing in individual MLPs rather than a passive index fund that also include exposure to a number of marginal names, these offerings generally feature lower expense ratios that the MLP-focused CEFs and mutual funds that are on the market. That being said, many of these offerings lack sufficient liquidity, which can make it difficult to trade in and out of positions.

Investors should also steer clear of UBS E-TRACS 2x Monthly Leveraged Long Alerian MLP Index (NYSE: MLPL), a leveraged fund that isn’t appropriate for the majority of individual investors. Unsophisticated investors often incorrectly regard this ETN as a slam dunk, lured in by its high yield and the assumption that the fund will deliver two times the return of the Alerian MLP Index.

However, this vehicle is suitable only for short-term trades and has no place in a long-only portfolio. UBS E-TRACS 2x Monthly Leveraged Long Alerian MLP Index compounds its returns on a daily basis, saddling you with a loss on each day that you own the fund and the underlying index declines. This will ensure that the return over a longer holding period is likely nowhere near the return you would receive by investing in JPMorgan Alerian MLP Index ETN (NYSE: AMJ).

3. Mutual Funds


Source: Bloomberg, Morningstar

Not surprisingly, the literature associated with the eight MLP-focused mutual funds touts the group’s strong fundamentals and seeks to entice investors by emphasizing that adding exposure to MLPs through this structure will replace the headache of dealing with multiple K-1 tax forms with a single 1099 form.

Less attention is paid to the above-average fees that will eat into investors’ returns.

The eight mutual funds listed in the above table charge investors a front-end sales load of at least 5.5 percent, a fee that will reduce the size of your initial investment.

All mutual fund investors also face annual charges and deductions for various ongoing expenses, the majority of which are tabulated in a fund’s expense ratio, a figure that expresses these charges as a percentage of overall assets. That is, if a fund manages assets totaling $400 million and charges $2 million, it would report an expense ratio of 0.5 percent.

There are several elements to the expense ratio. Management fees are paid out of the fund’s assets to compensate the financial professionals who construct and maintain the fund’s investment portfolio. This category also includes any administrative fees, which pay for mailing prospectuses, annual reports and account statements to shareholders.

So-called 12b-1 charges constitute another major component of the expense ratio and are paid out of the fund’s assets. Charges that fall under this heading generally relate to marketing and distribution expenses, as outlined by the US Securities and Exchange Commission.

Over time, seemingly negligible differences in fees and expenses can substantially reduce an investor’s earnings. For example, if you sink $10,000 in a fund with a 10 percent annual return and yearly expenses of 1.5 percent, after 20 years the value of your investment would have grown to just under $50,000. Of course, if you had put this money into a fund with annual expenses of 0.5 percent, your return would exceed $60,000.

Remember that although the market’s fortunes will fluctuate with time, costs remain relatively constant and are one factor over which investors have a degree of control.

Although the majority of MLP-focused mutual funds feature solid portfolios, investors must question whether management’s expertise will offset the exorbitant expenses levied by these offerings. Thus far, only three of these funds–Famco MLP & Energy Income (INFRX), Maingate MLP (AMLPX) and Tortoise MLP and Pipeline (TORTX)–have outperformed the S&P 500 since their inception. At the same time, a three-year time frame is ideal for evaluating the value that the fund manager brings to the table.

Prospective investors should also note that some of these funds also feature early withdrawal fees, so make sure you’ve made up your mind before putting any money to work in these offerings.