Energy boom blasting out master limited partnership opportunities

Tax restrictions on mutual funds need a close eye to avoid a whack from Uncle Sam

May 8, 2014 @ 5:06 pm

By Jeff Benjamin

master limited partnership, mlp, taxes, investing, energy, fracking, mutual funds
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Say what you will about fracking, but it has become the most successful effort yet to move the United States toward true energy independence. And along with that energy production boom comes renewed attention on energy infrastructure investment opportunities that are taking the form of master limited partnerships.

In essence, as new drilling and production technology helps to get more oil and natural gas out of the ground, MLPs are representing the infrastructure to transport the commodities.

With all that in mind, the mutual fund industry, as usual, has scrambled to hitch its wagon to the movement with a growing list of funds that provide exposure to MLPs.

A basic screen by Morningstar Inc. uncovered about two dozen MLP funds, all of which have been launched since 2010.

Because the fund industry has been considerate enough to package MLP exposure inside investor-friendly mutual funds, ETFs and closed-end funds, the U.S. tax code hasn't yet caught up with the energy infrastructure boom. Investors in these funds could be hit with a big surprise if they're not careful.

One of the strongest arguments in favor of wrapping what are essentially tax-exempt energy infrastructure businesses inside a registered fund is to eliminate some of the tax-filing headaches. 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.

But depending on how the mutual fund is investing in MLPs, some new tax issues could nullify many of the advantages of owning the partnerships directly.

“Most MLP funds flunk the mutual fund test by having more than 25% of the portfolio invested in MLPs,” said Robert Gordon, president of Twenty-First Securities Corp.

Therein lies the rub.

As soon as a mutual fund portfolio goes beyond a 25% allocation to direct MLP investments, the fund loses its status as a registered investment company and converts, for tax purposes, into a corporation. The tax rate climbs to 35%. That can be a painful surprise for investors.

Mr. Gordon estimates that only about a half dozen of the MLP mutual funds are, in fact, limiting their MLP exposure to 25%.

“The cost of staying pure [and not paying corporate tax rates] is that 75% of the portfolio is not going to be invested in MLPs,” he added.

Mutual funds sticking to the 25% limit are often stuffing the 75% hole with energy-related exposure, which includes utility stocks. But some strategies are more creative than others.

The $620 million Eagle MLP Strategy Fund (EGLAX), for example, strives to keep the MLP strategy as pure as possible by investing in publicly traded MLP general partners, or parent companies, which do not count toward the direct-MLP exposure limits. Among the fund's top holdings are energy infrastructure operating companies such as Williams Companies Inc. (WNB), Oneok Inc. (OKE) and Kinder Morgan Inc. (KMI).

Malcolm Day, co-head of MLP strategies at Eagle Global Advisors, said the strategy identifies about a dozen publicly traded companies that use MLPs as the main driver of business.

The basic different between the general partners and the underlying MLPs is that the GPs tend to have lower yields and higher growth,” he said. “It's a way to invest in a similar theme in terms of the energy infrastructure build-out.”

Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, said investors have to decide whether they want a pure MLP fund, and the tax advantages that come with it, or if they want more general MLP exposure.

Either way, the field is wide open and it can take a bit of digging to know exactly how the funds are constructed.

“Not all of these funds are going to be structured the same,” Mr. Rosenbluth said. “The fact that Oneok is the biggest holding of the Eagle fund is a good example of how a fund can work its way around the restrictions in the MLP space.”

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