Summary

• Many MLP CEFs are currently selling at a discount, which may represent a rare buying opportunity.
• Two of the MLP CEFs (KED and KMF) have significantly outperformed a basket individual CEFs (represented by AMLP).
• MLP CEFs offer excellent diversification for an equity-oriented portfolio.

I wrote an article last December about how to use Master Limited Partnerships (MLPs) to spice up your portfolio. At that time, many of the MLP Closed End Funds (CEFs) were selling at a premium due to their excellent performance in a low interest rate environment. However, this summer interest rates concerns caused these assets to be hit hard and many of the premiums evaporated. Currently, many of the MLP CEFs are selling at a discount, which renewed my interest in these assets. To determine if this is a buying opportunity, I evaluated these CEFs in terms of reward versus risk over the last several years.

For those who have not read my previous article, I will summarize some of the unique aspects of MLPs. This will be a high-level overview since I am not qualified to cover all the tax-related nuances of MLP investing.

MLPs have relatively complex rules stemming from the Revenue Act of 1987, which provided tax advantages to partnerships that earn at least 90% of their income from qualified sources, primarily energy and natural resource activities. MLPs do not pay any income tax as long as they make quarterly distributions of at least 90% of their earnings to shareholders (called unit holders in the partnership structure). However, Regulated Investment Companies (RICs) are prohibited from having more than 25% of their investments in MLPs. Most mutual funds, Exchange Traded Funds (ETFs), and CEFs are organized as RICs, which prevents them from being pure MLP plays; these funds usually round out their portfolios with subsidiaries and affiliates of MLPs.

However, fund companies on Wall Street are creative and they figured a way around the RIC limitation by organizing as C-corporations. These corporations may invest exclusively in MLPs but must pay corporate income tax. This may not be as detrimental as it sounds since MLP investments, as discussed below, offer ways to minimize taxes. The expense ratios usually quoted for CEFs are management and interest fees and do not normally include taxes.

Most MLPs operate in the midstream portion of the energy production cycle which involves the storing, transporting, or processing of energy (as opposed to upstream exploration or downstream retail sales). These MLPs typically have huge infrastructure expenditures, such as pipelines and processing plants. In terms of taxes, these infrastructure investments can be depreciated each year. When an MLP pays out a distribution, the lion’s share comes from depreciation allowances and is treated by the IRS as return of capital (ROC). This return of capital serves to reduce the basis associated with the MLP purchase and taxes are not paid until the MLP is sold.

So when a C-Corp fund receives a distribution from one of its constituent MLPs, the fund is able to write down the basis of the investment for the ROC portion of the distribution. Over the years, the fund often builds up relatively large amounts of deferred tax liability that will not be realized until the MLPs are sold. By IRS rules, these liabilities reduce the Net Asset Value (NAV). Astute investors recognize that the NAV has been artificially lowered, so these investors may be willing to pay a premium over the reported NAV. This is why MLP CEFs often sell at premium prices.

Return of Capital is an important concept when investing in MLPs and deserves some additional discussion. One of the key things to realize that the definition of ROC is not the common sense idea of receiving back your own funds but is instead based on accounting and tax rules. Not all ROC is considered bad. Because of depreciation, MLPs often have much more cash that can be used for distributions than is recorded as income. By accounting rules, this cash is designated as return of capital. This type of ROC is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase.

There are currently 26 MLP CEFs listed on CEFConnect. but many of these were launched after 2011 and do not have a long track record. I will limit my analysis to funds that:

1. Have at least a 3-year history
2. That trade at least 50,000 shares per day
3. Have a market cap of at least $200 million

The following 11 funds passed all my criteria:

Kayne Anderson Midstream Energy (NYSE:KMF ). This is a CEF structured as a RIC. The fund sells at a discount of 11.7%, which is below the 52-week average discount of 9.6% (over a 3-year period, the average discount was only 5.4%). The portfolio consists of 100 holdings, 90% of which are invested the midstream/energy sector consisting of pure MLPs as well as MLP subsidiaries and affiliates. The fund uses 30% leverage and has an expense ratio of 3.9%, including interest expenses. The distribution is 5.8% with no ROC.

Kayne Anderson Energy (NYSE:KYE ). This is a CEF structured as a RIC. The fund sells at a 9.5% discount, which is below the 52-week average discount of 5.5% (over the past 3 years, the discount has average less than 1%). This fund has 96 holdings with 92% in MLP-associated companies in the energy sector. The fund utilizes 29% leverage and has an expense ratio of 3.3%, including interest payment. The distribution is 6% consisting of income, capital gains, and non-destructive ROC. This is one of the few MLP CEFs that has a history back to 2005 so we can obtain some sense of how MLPs performed in the 2008 bear market. In a word, KYE performed poorly, losing over 50% in 2008.

Kayne Anderson MLP (NYSE:KYN ). This CEF is structured as a C-corporation and sells for a discount of 0.3%, which is well below the 52-week average premium of 4.8% (over 3 years, the premium has averaged 7%). It holds 71 MLP securities and uses 32% leverage. The expense ratio is 2.6% including interest. The distribution is 6.1% consisting of income and non-destructive ROC. This fund also has a long history and lost over 50% of its NAV in 2008 (but the price only declined 40%).

Kayne Anderson Energy Development (NYSE:KED ). This CEF is structured as a C-corporation and sells at a premium of 7.1%. This CEF has typically sold at a discount (4.8% over the past year and 1% over the past 3 years), so the current premium makes this CEF more expensive than normal. The fund holds 55 securities, all MLPs, and utilizes 22% leverage. The expense ratio is 3.8% and the distribution rate is 5.3%, all from income with no ROC.

Fid/Claymore MLP Opportunity (NYSE:FMO ). This CEF is structured as a C-corporation and sells for a discount of 3%, which is below the 52-week average premium of 1.5% (over 3 years, the premium has averaged 5.2%). This fund has 47 holdings, all MLPs. It employs 23% leverage and has an expense ratio of 1.9% including interest payments. The distribution is 6.0%, consisting mostly of non-destructive return of capital. FMO performed relatively well in 2008, losing 35% in price and 46% in NAV.

ClearBridge Energy MLP (NYSE:CEM ). This CEF is structured as a C-corporation and sells for a discount of 9.5%, which is well below the 52-week average discount of 1.5% (over 3 years, the fund has sold at an average premium of 1.6%). The portfolio has 38 holdings, all of which are MLPs. The fund utilizes 21% leverage and has an expense ratio of 1.9%, including interest payments. The distribution is 6.3%, which is mostly non-destructive return of capital.

ClearBridge Energy MLP Opportunities (NYSE:EMO ). This CEF is structured as a C-corporation and sells for an 11.8% discount, which is lower than its 52-week average discount of 6.4% (over 3 years, the fund has experienced an average discount of only 1.6%). The fund holds 45 MLPs and utilizes 21% leverage. The expense ratio is 2.3%, including interest payments and the distribution rate is 5.7%, most of which is non-destructive ROC.

Tortoise MLP Fund (NYSE:NTG ). This CEF is structured as a C-corporation and sells for a discount of 9%, which is lower than the 52-week average discount of 5% (over 3 years, the fund sold on average near its NAV). The fund holds 31 MLPs and uses leverage of 26%. The expense ratio is 1.5% and the distribution rate is 5.9%, consisting mostly of non-destructive ROC.

Tortoise Energy Infrastructure (NYSE:TYG ). This CEF is structured as a C-corporation and sells at a discount of 10%, which is well below the 52-week average premium of 1% (over 3 years, the premium has averaged 8.5%). The fund holds 33 MLPs and utilizes 25% leverage. The expense ratio is 1.7% and the distribution is 5.2%, all from income with no ROC. During 2008, this fund lost 45% in both price and NAV.

Cushing MLP Total Return Fund (NYSE:SRV ). This CEF is structured as a C-corporation and sells for a whopping 20.7% premium, which is higher than its 52-week average premium of 19% (over 3 years, the premium has also averaged 19%). The fund holds 56 securities with about 89% invested in MLPs. The fund uses 31% leverage and has an expense ratio of 2.2%. The distribution is a large 10.4% (which is likely the reason for the large premium), most of which is non-destructive ROC.

Nuveen Energy MLP Total Return (NYSE:JMF ). This CEF is structured as a C-corporation and sells at a discount of 9.7%, which is below the 52-week average discount of 6.7% (the 3-year average is also a 6.7% discount). The fund holds 45 MLPs and utilizes 25% leverage. The expense ratio is 2% and the distribution rate is 5.9%, consisting mostly of non-destructive ROC.

For reference to a passively managed basket of MLPs, I have also included the following ETF.

ALPS Alerian MLP ETF (NYSEARCA:AMLP ). This is an ETF that tracks the Alerian MLP Infrastructure Index, which consists of 25 pipeline and processing MLPs. This is one of the few ETFs that tracks MLPs (most are structured as Exchange Traded Notes). AMPL is structured as a C-corporation to avoid the 25% limitation for MLP ownership. This has become one of the fastest-growing exchange traded products, with an average daily volume of over 3 million shares. This ETF does not utilize leverage and has a low expense ratio of 0.85%. It has a yield of 5.7%.

To assess the risk-adjusted return of these MLP funds, I used the Smartfolio 3 program. Figure 1 provides the rate of return (called Excess Mu on the charts) in excess of the risk free rate. This rate of return is plotted against the historical volatility over the past 3 years for each of the MLPs.

Figure 1. Risk vs. Reward over past 3 years

As illustrated by the figure, over the past 3 years, there has been a wide range of returns and volatilities associated with MLP funds. A fund like KED has a relatively high volatility but also had a large return. Was the return commensurate with the volatility risk? To better assess the relative performance, I calculated the Sharpe ratio.

The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with the AMLP. If an asset is above the line, it has a higher Sharpe Ratio than AMLP. Conversely, if an asset is below the line, the reward-to-risk is worse than AMLP.

Some interesting observations are evident from the figure:

1. There was not a significant trend in performance between CEFs structured as RICs and those structured as a C-corporation. Of the two CEFs structured as RICs, KMF had excellent performance while KYE lagged most of the other CEFs.
2. The reference ETF was substantially less volatile than the CEFs, but also had lower return. On a risk-adjusted basis, the ETF outperformed all but two of the CEFs (KED and KMF).
3. The CEF with the largest premium (SRV selling at a premium of over 20%) had the worst absolute and risk-adjusted performance. The volatility is increased by the large fluctuations in premium. Although this CEF provides the highest distribution, the risk-adjusted performance lagged the other CEFs.
4. The second CEF selling at a premium (KED selling at a premium of about 7%) had excellent absolute and risk-adjusted performance, so the premium may be justified for this CEF.

Since all the funds were invested in MLP funds, I wanted to assess how much diversification you might receive by buying multiple funds. To be diversified, you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. I also added the SPDR S&P 500 ETF (NYSEARCA:SPY ) to assess the correlation of the funds with the S&P 500. The results are presented in Figure 2 and are enlightening. First off, the MLP funds are not highly correlated with SPY. This implies that you do receive substantial diversification effects by adding these funds to either a stock portfolio. Should you invest in more than one fund? Somewhat surprisingly, the CEFs were not highly correlated with one another, so you would receive diversification benefits from having multiple MLP CEFs in your portfolio.

Figure 2. Correlation over the past 3 years

Lastly I wanted to see if the risk-reward characteristics were maintained over a more recent period when the S&P 500 was enjoying a rip-roaring bull market. I reduced the look-back period to 12 months and re-ran the analysis. The results are shown in Figure 3.

Figure 3. Risk versus reward over the past 12 months

During the past year, the MLP ETF continued to have better risk-adjusted performance than most of the CEFs, beating all but KED, KMF, and FMO. KED and KMF continued to provide excellent absolute and risk-adjusted performance. FMO improved in relative performance. SRV had better performance over the near term, but only managed to land in the middle of the other CEFs.

Before leaving MLPs, I should mention one of the tax filing advantages of using funds rather than individual MLPs. For individual MLPs, you will receive a K-1 partnership form for each partnership. The K-1 form is vastly different and much more complicated than the simple 1099 form for stock dividends. Although MLPs try to make filing a K-1 as easy as possible, it is still complex and confusing. To make matters worse, K-1 forms are not required to be issued until 15 March, much later than the January 31 date for 1099 forms. Thus, you may need to delay your tax filing until you receive all your K-1s. If you invest in MLP funds, you don’t have to deal with K-1 forms; your distributions are reported on a simple 1099 form, just like your other investments.

Bottom Line

MLP CEFs do not often sell at a discount, so I believe the recent price weakness represents a buying opportunity for selected CEFs. The long term prospects for MLPs are still bright. As the United States becomes more energy-independent, there will be a growing demand for transporting oil, natural gas, and other fuels to their end markets. This will result in a sweet spot for pipeline and mid-stream MLPs.

MLPs usually have large amounts of debt associated with maintaining their infrastructure, so higher interest rates present risks for this asset class. However, if interest rates remain low, as promised by the Fed, MLPs will be able to borrow cheaply, increasing their profits. On the other hand, if the economy falters and the market sinks into another 2008-style bear market, MLPs will not offer you protection.

No one knows what the future will hold, but based on past performance, this asset class should be considered a worthy addition to your portfolio.

Disclosure: The author is long KYN, CEM, KMF, FMO, AMLP. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.