As yield-generating investments, master limited partnerships have plenty of appeal, but it would be difficult to find another asset class with more ways to unintentionally trip up investors.
The latest challenge is weighing the pros and cons of mutual funds with more than 25% exposure to direct MLP investments, which automatically convert the fund from a registered investment company to a corporation, subject to corporate-level taxes.
Adding those taxes can introduce a 4% to 5% drag on performance.
Some fund managers, such as Eagle Global Advisors LLC, are avoiding the corporate tax by limiting direct MLP exposure and relying heavily on other types of infrastructure investments.
“We're looking at performance first and foremost, but we're also trying not to lose performance because of the double taxation,” said Greg Anderson, co-adviser of the Eagle MLP Strategy Fund (EGLAX) and chief investment officer at Princeton Fund Advisors LLC.
The $75 million fund, which was launched in September, has gained about 19% so far this year.
The equity energy category, as tracked by Morningstar Inc., gained 11% over the same period.
“Our rule is no more than 25% directly invested in MLPs, and for the rest of the portfolio, we own either MLP proxy investments or energy infrastructure in different formats,” Mr. Anderson said. “I think, over time, you'll see more funds created to overcome the tax drag.”
Morningstar doesn't have a designated category for MLP funds, but it follows more than a dozen mutual funds and exchange-traded products that invest in MLPs.
The flip side of the case for avoiding the double tax comes from the purists, who contend that limiting a portfolio to 25% MLP exposure is too diluted to be effective.
“We looked at [limiting MLP exposure to 25%], and we didn't like it, because it significantly handicaps what you can buy as a portfolio manager,” said Brian Watson, portfolio manager and director of research at OFI SteelPath Inc., which is part of OppenheimerFunds Inc.
The $1.3 billion flagship Oppenheimer SteelPath MLP Alpha Fund (MLPAX), which is taxed as a corporation, is up about 14.3% from the start of the year.
“We want to invest in infrastructure, and we don't want to have our hands tied behind our back in terms of what we can invest in,” Mr. Watson said.
Like a lot of investment puzzles, this one can be traced to some variation of market forces, but the current status of MLPs involves an expanding maze of investment entry points of which financial advisers should be mindful.
For starters, there is the obvious allure of MLPs, which includes an average yield of about 6.6%, or about 4.8 percentage points above the 10-year Treasury bond. That kind of income amid such low interest rates has predictably whetted the appetite of the financial services industry, which has spent the past few years finding creative ways to wrap MLPs inside registered products.
And that is where the fun begins. Investors can gain access to MLPs either directly, through a separately managed account, in closed-end mutual funds, open-end mutual funds and various exchange-traded products.
Each access point has its share of pros and cons, and there is nothing close to a free lunch here. But that doesn't mean this isn't an asset class worth considering.
Thanks to the Tax Reform Act of 1986, designed to boost investment in mostly energy-related infrastructure products, MLPs are able to provide attractive tax advantages.
Avoiding double tax
Unlike traditional corporations, MLPs operate as limited partnerships and pay no tax at the company level, allowing investors to avoid the double tax on dividends.
For direct-MLP investors, not only are the quarterly distributions deferred until the investment is sold, but most of the distribution actually is a return of capital, which constantly lowers the investor's cost basis.
A significant wrinkle with MLP investing, whether held directly or through a separate account, is the tax-reporting challenges that could involve filing taxes in dozens of states where an MLP operates.
One way around the tax-filing headache is wrapping MLPs inside a registered product such as a mutual fund or ETF, but in many cases, that eliminates the tax advantages of owning MLPs. Once MLPs are wrapped in a mutual fund or an ETF, their distributions are taxed at the fund's corporate rate, and what is left is paid to shareholders as a distribution. That payment then is taxed as dividend income, thereby effectively nullifying the main reason for investing in an MLP in the first place.
Some critics of limiting direct-MLP exposure contend that there aren't enough non-MLP investments and proxies to effectively build a diversified portfolio.
But a bigger factor preventing more funds from trying to avoid the corporate-level tax is that investors and advisers aren't yet paying attention and, thus, forcing the fund industry to change.
“This seems like an opportunity,” said Todd Rosenbluth, a fund analyst at S&P Capital IQ. “I don't know why more fund companies aren't doing this yet.”