MLP funds aren’t all they are cracked up to be

In this yield-starved and tax-sensitive environment, it is no wonder that master limited partnerships are being touted as the next hot investment solution. After all, the sales pitch promises long-term tax deferrals on annual distributions, with yields now about 7%.

But before jumping into one of the handful of packaged MLP products already on the market, financial advisers should be mindful of the various moving parts and idiosyncrasies in the MLP arena.

The first MLP mutual funds were launched in May by SteelPath Fund Advisors, and they have already attracted more than $500 million. The biggest players in the mutual fund industry are probably already ramping up their own designs for packaging these unique infrastructure partnerships into products for the retail masses.

There are also a handful of exchange-traded funds, closed-end funds and exchange-traded notes that already invest in MLPs.

The bonus for wrapping MLPs inside a mutual fund or ETF is that the traditionally arduous tax-reporting issues, which can involve dozens of separate filings, are nullified for the individual investor.

But though products such as the SteelPath suite of funds provide easy access to what is expected to be a fast-growing category, these retail-oriented products also come with trade-offs that could reduce or even eliminate some of the most important advantages of MLP investing.

The MLP tax benefits can be traced to the Tax Reform Act of 1986, which was designed to boost investment in mostly energy-related infrastructure projects. Unlike traditional corporations, MLPs operate as limited partnerships and pay no tax at the company level, avoiding the double tax on dividends.

For direct MLP investors, much of the appeal is that the taxes on the quarterly distributions are deferred until the investment is sold and can even be avoided entirely if held until the investor’s death.

And because most of the distribution is actually a return of capital, which lowers an investor’s cost basis, there is a strong incentive for investors to hold an MLP for as long as possible. For example, if an MLP is purchased for $100 a share, a 7% distribution will lower the cost basis to $93.

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

“MLPs are things that people buy and die with,” said Paul Justice, an analyst at Morningstar Inc.

That kind of long-term investor mentality, fueled by an enthusiastic fund industry, could result in an MLP market bubble as new buyers drive up share prices, he said.

With a total market size of about $200 billion invested across fewer than 80 MLPs, the entire category is actually smaller than Microsoft Corp.

“The mutual funds have been popular and you will see more,” Mr. Justice said. “But this is not a large space, so you have to wonder how many funds it can support.”

But proponents of packaged MLP products paint a different picture.

Gabriel Hammond, co-founder of SteelPath Fund Advisors and manager of the new funds, said that the MLP market is in need of at least $500 billion in new capital and that daily trading volume is already about $600 million.

“In the next year, we expect our fund to be at $2 billion, and more funds will create greater liquidity,” he said. “We’re in a really sharp exponential move here, and I don’t think we’ll have much of a liquidity impact on the market.”

But even if a rush of new mutual fund money doesn’t overwhelm the MLP market, there is the added twist of losing control over when and how taxable gains are recognized. If net redemptions force a fund manager to sell out of some MLP positions, the cost basis step-down advantage suddenly becomes a significant taxable event that is absorbed by every investor in the fund.

“People buy MLPs for tax efficiency, and that’s the only reason to buy them,” said Dan Plettner, who manages a portfolio of 16 individual MLPs on the Covestor Investment Management platform.

He described MLPs held in packaged products as “potential time bombs.”

“The whole reason MLPs are in vogue right now is because of the increased dividend taxes,” Mr. Plettner said. “All the packaged products really do is throw the tax advantages out the window.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].