Direct investment in publically traded MLPs is a suitable option for many investors, but others may prefer additional diversification or less of an administrative burden. In this case, there are a number of closed-end funds and exchange traded products which provide an efficient alternative and can simplify the tax aspect for individuals. We think these funds also help the liquidity and overall sustainability of MLPs as an asset class, ultimately driving new cash flows into the sector.
Unlike a typical equity or bond mutual fund, which is treated as a Regulated Investment Company (RIC) for tax purposes, MLP ETFs and closed-end funds are taxed as a C corporation, eliminating the need to file a K-1. Because MLPs themselves have no entity-level tax, the IRS requires any open-ended or closed-ended fund that invests more than 25% of its assets in MLPs to be taxed as a C corporation. And because the fund is a corporation, it can pass through 100% of dividends and the character of that distribution stays the same. In other words, distributions from these funds may be classified as a return of capital.
This creates a unique situation for a number of MLP funds in that the C corporations must accrue deferred income taxes for any future tax liability associated with (1) the portion of MLP distributions considered to be a tax-deferred return of capital and (2) capital appreciation or depreciation of the underlying securities. Accordingly, the net asset value of the fund will be reduced (or enhanced) by this deferred tax liability (or asset) and performance will be affected in a similar manner – meaning investors will generally give up some of the upside in the underlying index in exchange for a buffer on the downside. This is a trade-off we are generally happy to make, particularly when it is accompanied by ease-of-use in terms of tax reporting.
ETNs, which also issue a 1099 for income paid out each year, are not subject to corporate taxes, but neither are they tax advantaged; unlike ETFs, they expose investors to the credit risk of the issuer. This is generally not a trade-off we are willing to make given the size and opacity of bank balance sheets today. Because the quarterly distribution for an ETF will typically be similar to that of its underlying companies (i.e. a return of capital), after-tax ETF distributions will generally be significantly greater than the after-tax ETN distribution.
The evidence of slower trend growth in the aftermath of debt-induced financial crises is well-rehearsed even by the most consensus, institutionalized investment managers at this point. However, we still think the majority are missing the most important point. The average low in interest rates in many of these academic studies occurred almost fourteen years after the initial panic and even twenty years later, long-term yields were still very depressed. In other words, baby boomers and future retirees are likely to remain starving for yield for the foreseeable future.
Portfolio theory would suggest that investors should focus on total return, rather than exclusively on yield. But most investors still face a difficult choice ahead: take more risk or accept less income. Fortunately, we have uncovered a number of compelling alternatives to replace more traditional sources of cash flow. It is entirely possible to create a high yielding portfolio with dampened volatility by combining an allocation to MLPs with high yielding segments of the fixed income market to provide the most yield at an acceptable level of risk. An investor’s allocation to MLPs in a portfolio depends on investment objectives and risk tolerance, but in general, our investment ranges from 5% to 10% of assets under management today.
Periodic spikes in interest rates, as we’ve experienced in each year of the current economic “recovery,” come as no surprise to investors. Market driven rates simply do not move in a straight line. But the trend is clear. And as such, we remain constructive on the long term potential for MLP performance given the following factors: (1) Growth in domestic production of oil and gas should continue to drive demand for energy infrastructure, supporting monopolistic, visible, fee-based and long-term growth opportunities for the sector; (2) MLPs currently trade in-line with five and ten-year historical valuation metrics and we expect a gradual rerating of the sector; Finally, (3) robust yields, and growing distributions should continue to attract capital in a low interest rate environment, while real assets provide a natural inflation hedge and portfolio diversification.