MainStay Investments is jumping into the white-hot master limited partnership space by absorbing three MLP mutual funds managed by Cushing Asset Management.
The funds, MainStay Cushing MLP Premier (CSHAX), MainStay Cushing Royalty Energy Income (CURAX) and MainStay Cushing Renaissance Advantage (CRZAX), will continue to be sub-advised by the Cushing team, but will now benefit from the distribution network of MainStay and its parent, New York Life Insurance.
“We have a very positive long-term view of growth in the energy sector,” said Kirk Lehneis, managing director at MainStay Investments.
MainStay president Stephen Fisher called the “U.S. energy renaissance one of the greatest economic stories or our time.”
The basic appeal of MLP investing is twofold, including access to a fast-growing energy infrastructure that is supporting the North American energy boom, as well as the income potential of investments designed to pay out most of the profit to investors.
The average dividend yield for MLP open-end mutual funds is 4.8%, but many of the funds have also generated strong total return performance this year.
Morningstar Inc. doesn't have a specific category for MLP funds, but of the 22 fund it identifies as investing in MLPs, all but one has gained more than 10% this year, and three have gained more than 21%.
Of the three MainStay Cushing funds, MLP Premier is up 13.8% this year, Royalty Energy Income is up 7.5% and Renaissance Advantage is up 14.9%.
While past performance might be a good way to start the due diligence process, lots of moving parts should be considered when it comes to investing in MLP mutual funds.
The original idea behind the MLP mutual fund was to give retail investors access to steady income generation from energy infrastructure companies.
By wrapping MLPs in a mutual fund, investors are able to avoid the complex 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 is actually 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.
Packaging MLPs inside a structure such as a mutual fund provides easy and diversified access to retail investors, but it also mutes many of the tax advantages, and that's what advisers should be watching.
For starters, unlike most open-end mutual funds, MLP funds typically are structured as C corporations and have to pay taxes at the corporate level.
The only way to avoid this corporate-tax drag is to limit the exposure to direct MLP ownership to 25%, otherwise the mutual fund automatically converts from a regulated investment company into a C corporation.
Fund investors in C corporation MLP funds also face the same cost basis step-down issues as direct MLP investors, because most of the fund's yield is counted as a return of capital.
In basic terms, consider an MLP fund that owns a single underlying MLP, trading at $100 per share.
In the first year, an 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 taxed again at the individual investor level as dividend income.
While it might add up to a good deal for government tax collectors, it can amount to a perplexing surprise for investors.
For advisers, the MLP space introduces a new level of due diligence because the registered retail products are not all created equal.
“There is definitely more due diligence needed to find out if a fund is a C corp. or a RIC,” said Quinn Kiley, manager of the Advisory Research MLP & Energy Income Fund (INFIX), which maintains its RIC status by limiting direct MLP ownership.
“Our general take has been that if you're a large enough investor to be able to deal with the tax headache of owning MLPs directly, that's the most cost-effective and tax-efficient way to own them” he added.
When it comes to MLP exposure, retail investors also could turn to some of the closed-end funds, which will often add leverage in order to offset some of the additional tax drag. But that can introduce a different type of investment risk related to leverage.
Some exchange-traded notes also offer MLP exposure, but as Mr. Kiley explained, an ETN is essentially a fixed-income product, which introduces counterparty risk.