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Key Differences Between MLP Funds

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Energy master limited partnerships (MLPs) have an enviable performance record. Over the 3-, 5- and 10-year periods ending June 30, 2011, the Alerian MLP Index (AMZX) of 50 prominent MLPs has outperformed REITs, the Dow Jones Industrial Average, utilities and the S&P 500. Additionally, MLP-investors continue to benefit from high, tax-advantaged and increasing distributions.

 The main drawbacks for prospective investors are MLPs’ tax accounting with the dreaded Form K-1 and the potential for unrelated business taxable income (UBTI) treatment if the MLP units are held in a retirement plan. Separate managed account managers who invest in MLPs downplay the importance of these two features; nonetheless, they matter for many advisors.

MLP Chart

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“Many advisors do not want to receive K-1s for their clients and a lot of that goes back to their underlying clients who tell their advisors I don’t want to deal with K-1s,” said Gabriel Hammond, founder of SteelPath Fund Advisors in Dallas, in an interview with AdvisorOne.

“So direct (MLP) ownership through a separately managed account or a private fund typically isn’t an option for advisors allocating across a wide client base,” Hammond explained. “They want an investment vehicle that they can allocate across all of their accounts regardless of the size of the investor, regardless of whether, for example, it’s an IRA or 401(k) plan. They want an investment vehicle option that’s essentially one size fits all; that’s plug-and play-across their investment platform.”

Until 2009, closed-end funds were the only available alternative to direct MLP-ownership. Since then, however, numerous exchange-traded funds (ETFs), open-end funds (OEFs) and exchange-traded notes (ETNs) have launched. Although the structures vary, they share several features. First, they provide diversified portfolios. Second, these funds report on the more familiar Form 1099 instead of K-1s.

There are some key differences among the funds, however, and those differences can be significant. In its MLP Monthly: July 2011 issue, Wells Fargo Securities reviewed MLP funds’ one-year performance versus the Wells Fargo MLP Index.

The included table’s results highlight the point that investment results can vary among the fund categories. I’ll explore the origins of those differences, especially the tax-impact of a fund operating as a C corporation, in future columns.

Also, here are some key factors to evaluate when you’re considering MLPs for clients.

K-1s and UBTI from direct ownership: If that’s a goal, your choices are restricted to funds organized as C corporations or senior debt instruments (ETNs). Corporate-form funds pay federal income tax; accounting for that tax influences returns positively in down markets and negatively in up markets.

MLP index tracking: Not all MLP funds are designed to track an MLP-industry index—the portfolio’s objective may dictate the use of a broader market index as the appropriate benchmark. If the goal is to capture an index’s results, invest through an ETN.

Portfolio leverage: CEFs typically use leverage to offset the tax impact from their corporate form. Leverage can magnify investment returns and losses.

Distributions’ income tax treatment: ETN distributions are taxed as ordinary income (outside of a retirement account, of course). Distributions from the other fund-types may consist of return of capital, dividends or ordinary income.

Distribution growth: Wells Fargo found that MLPs’ distribution growth was significantly higher than CEFs. The five-year compound annual growth rate for MLP distributions was 6.3 percent versus 3.3% for MLPs.

The growing number of investment options for accessing MLPs has benefited investors. Still, it makes sense to consider how each of the fund types has performed relative to your clients’ investment goals.