Investment Insights

Jeff Benjamin

MLP mutual funds: A bad wrap?

Jul 22, 2012 @ 12:01 am

By Jeff Benjamin

The planned acquisition of SteelPath Capital Management LLC by OppenheimerFunds Inc. is much more significant than just a $176 billion asset management company's absorbing a $2.6 billion boutique firm.

The deal, which was announced last week and is scheduled to close in the fourth quarter, represents the first major move by a fund industry stalwart into the somewhat obscure area of master-limited-partnership mutual funds.

Given Oppenheimer's distribution and marketing muscle, it means that financial advisers and investors will start hearing and seeing a lot more about MLP funds. Although no doubt they will hear all the virtues of these alternative investments, they should also know their drawbacks — and there are a few.

For example, one of the strongest arguments in favor of wrapping what are essentially tax-exempt energy infrastructure businesses inside a mutual fund is to eliminate some tax-filing headaches.

However, as Morningstar Inc. analyst Paul Justice points out, holding MLPs inside a mutual fund introduces some new tax issues and nullifies many of the advantages of owning MLPs directly.

TOUTING THE DEAL

For now, both companies are touting the deal.

For SteelPath, which launched the industry's first MLP mutual fund two years ago, it is a way to expand its management of MLP assets through Oppenheimer's expansive marketing and distribution network.

At OppenheimerFunds, the deal represents a turnkey expansion of its lineup of alternative investment strategies.

“We had the discussions extensively about launching our own [MLP funds], but to build it from scratch would have taken us some time and several years to accumulate the track record to get on some platforms,” said Art Steinmetz, OppenheimerFunds' chief investment officer.

“MLPs systematically fit well into our plan to beef up our alternative investments capability,” he said.

The number of MLP mutual funds still is small, with about a dozen funds holding a total of $3.5 billion in assets, the bulk of which is in SteelPath funds, according to Morningstar.

The original idea behind the MLP mutual fund, as created by SteelPath founder and chief executive Gabriel Hammond, was to give retail investors access to steady income generation from energy infrastructure companies, which are required to distribute most of the profit to investors.

By wrapping MLPs in a mutual fund, he also was able to help investors avoid Schedule K-1 tax reporting, which can require filing tax returns in dozens of states.

The mutual fund format generates a single Form 1099, regardless of where the underlying MLP businesses are operating.

The MLP tax benefits can be traced to the Tax Reform Act of 1986, which was designed to encourage investment in energy-related infrastructure projects such as pipelines. 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.

Over time, the cost basis step-down process could even go into negative territory while the actual share price is climbing, creating the kind of taxable event that most investors would want to avoid.

NO TAXES

“The biggest advantage of owning an MLP directly is that you don't pay taxes on them until you sell them, and that's why investors tend to hold them until they die,” Mr. Justice said.

Although packaging MLPs inside a structure such as a mutual fund does provide easy and diversified access to retail investors, it also mutes some of the tax advantages.

For starters, unlike most open-end mutual funds, the MLP funds typically are structured as C corporations and have to pay taxes at the corporate level, Mr. Justice said.

Fund investors also face the same cost basis step-down issues as direct investors, because most of a fund's yield is counted as a return of capital.

In basic terms, consider an MLP fund that owns just one underlying MLP, trading at $100 a share.

In the first year, a standard annual distribution of 7%, or $7, would lower the cost basis by about $5, lowering the original purchase price to $95 for tax purposes.

The remaining $2 worth of annual income would be treated as a dividend distribution taxed first at the corporate level, reducing the payout to the shareholder by about 30%, then at the individual-investor level as dividend income.

DOUBLE DIP

“There are two different tax impacts with the MLP funds,” Mr. Justice said. “The government is doing really well in this situation.”

Tax issues aside, Mr. Hammond has a legitimate point when he trumpets the strategy as “[Treasury inflation-protected securities] on steroids.”

MLP businesses are able to generate yields in the 7% range because they hold long-term inflation-adjusting leases with energy-related companies that provide steady income, regardless of energy price fluctuations.

Of course, the flip side of such a yield-rich strategy is vulnerability in a rising-interest-rate environment, Mr. Justice said.

“If rates start rising, they will act more like bonds than equities, because they are basically just yield-producing investments,” he said.

Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com Twitter: @jeff_benjamin

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

May 02

Conference

Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in four cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Featured video

Events

What's the first thing advisers should do when they get home from a conference?

After attending a financial services conference, advisers can be overwhelmed by options, choices and tools. What's the first thing they should do when they get back to their office?

Latest news & opinion

Galvin's DOL fiduciary rule enforcement triggers industry plea for court decision

Plaintiffs warned the Fifth Circuit that Massachusetts' move against Scottrade signaled that the partially implemented regulation can raise costs for financial firms.

Social Security underpaid 82% of dually entitled widows and widowers

Agency failed to tell survivors that they could switch to a higher retirement benefit later.

Is Fidelity competing with retirement plan advisers?

As the Boston-based mutual fund giant expands the products and services it brings to the retirement market, some financial advisers say the firm is encroaching on their turf.

Gun violence hits investment strategies, sparks political debates with advisers

Screening out weapons companies has limited downside.

Whistleblower said to collect $30 million in JPMorgan case

The bank did not properly disclose that it was steering asset-management customers into investments that would be profitable for JPMorgan Chase.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print