There is around $53BN invested in MLPs via ’40 Act funds – the term used to describe the three major types of funds issued under the 1940 Investment Company Act (mutual, exchange traded and closed end funds). It’s safe to say that an important motivating factor driving these selections is investors’ desire to hold Master Limited Partnerships (MLPs) without receiving K-1s. ’40 Act funds issue 1099s, which makes tax reporting simpler. We have warned before about these frogs masquerading as princes (see Are You in the Wrong MLP Fund?)
Providing investors MLP exposure while avoiding the K-1s was once an objective of industry pioneers who identified a new source of capital from retail investors, if only this problem could be solved. Although much energy and expensive tax advice were deployed, an elegant solution remained elusive at that time. All that remained was a decidedly inelegant one – offer retail investors shares in a C-corp, which would hold MLPs and issue its investors a 1099. The significant problem with this solution was that the C-corp’s returns would be subject to Federal Corporate Tax, as with any corporation. The investors in this C-corp would only receive 65% of the result, since 35% would go to the IRS.
Some dismissed this “solution” as impractical. After all, who would knowingly make an investment that could only earn around two thirds of what the assets themselves generate? But the absence of a better (i.e. more tax-efficient) solution frustrated a few, and they redirected their attention away from solving the problem to instead convincing investors that a deeply flawed structure was what they really wanted.
The result is that 83% of the $53BN mentioned above is invested in vehicles that have no hope of ever coming close to earning the return of the MLP sector. A careful reading of prospectuses issued by the offending vehicles reveals wording that is technically accurate while still misleading.
Quite a few claim an objective of results corresponding to their chosen index before fees and expenses. Since ’40 Act funds (outside of MLP funds) are very largely RIC-compliant (which means they don’t pay corporate tax), few MLP fund investors consider that by far the biggest line item in the inferior funds’ list of fees and expenses is taxes.
The Alerian MLP ETF (AMLP), the largest repository of mis-directed capital by poorly informed investors, goes further and says it, “…delivers exposure to the Alerian MLP Infrastructure Index”. Exposure to an asset class is not the same as providing good results from investing in it. The carefully worded prospectuses of AMLP and its tax-hindered cousins are technically correct. But I can personally attest that few holders of such securities are aware that they’ve essentially tied their running shoes together at the start of the race. What’s worse is that the tax expense isn’t deducted from the yield, but comes out of the NAV. So the 7.5% yield on AMLP is before the corporate tax expense is paid. Imagine if a corporation paid all its pre-tax cashflow out in distributions and then wrote another, separate check to the U.S. Treasury, thereby reducing its book value. That’s what taxable C-corp MLP funds are doing.
Pointing out to such an investor the mistake they’ve made is not especially fun, and I’ve had to do it numerous times. It’s somewhat akin to noting the toxic dump near an unwitting home buyer’s recent purchase. The reaction to missing such an obvious value destroyer is usually a combination of embarrassment (at their own evidently shallow research) and anger at being guided towards a fundamentally flawed investment.
Picking a tax-paying MLP fund is an especially tragic choice when returns have been good, and in some cases very good indeed. Moreover, based on recent fund flows some new investors are making the same mistake. Holders of such funds are accepting the downside risk of the sector while only being able to earn 65% of any upside. This is careless to say the least. By choosing to invest in a fund that splits its profits two thirds/one third with Uncle Sam, these investors are supporting the tax base twice – once, before they get their returns, and again after they pay their own tax obligation on what’s left.
The list of such offending funds is too numerous to include here, reflecting the unfortunate tendency towards highly superficial investment research by too many investors. However, if you look at Morningstar’s list of MLP funds and sort by the 1 Year Return column, the structurally impaired can helpfully be found in an undignified heap languishing towards the bottom. At the top you’ll find the funds who thought enough of their investors to at least provide the non-taxable, pass-through structure they assumed they were buying.
If you’re invested in one of the lousy funds, correct that mistake sooner rather than later. And if your financial advisor has put you in one, you may wish to reassess the depth of research carried out on your behalf.
The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)
This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r
Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
Past performance of the American Energy Independence Index is not indicative of future returns.