MLP Closed End Funds: Proceed With Caution

by: Michael J. Ray
Today's retail income investor is on the hunt for yield and is being forced to do so outside what was once the traditional methods, like high rated bonds and CD's. Needless to the say, the investors will search all over the financial markets looking to see what financial instruments are available. Inevitably these investors will find the Master Limited Partnerships (MLP), with their seductive yields and potential promises of outsized capital gains. Who could blame them, as these investment vehicles can appear to be very attractive. After a bit more investigation though, many retail income investors might start to shy away as the tax structure is very different than the CDs or Treasury Bonds that they are used to. They will want to avoid the hassles of multiple K-1s and multiple state filings. But like a moth to a flame, the retail income investor will not be able to let go, as the yields are very competitive and the companies will have a reliable business model.
Eventually they will come across the Closed End Funds (CEFs) that focus on MLPs and think they have found the Holy Grail. They will be attracted to the same competitive yields and the easier tax structure by avoiding the K-1s. If our retail income investor stops their analysis here, they might be setting themselves up for some real, unforeseen trouble.
The risks in CEFs are well documented and fairly easy to identify. Most any type of CEFs will have some of these risks, but the funds that are focused on the MLP's business sector tend to be more exposed. Before we go into the individual CEFs, let's review these risks.
Net Asset Value (NAV)
One characteristic that CEFs have is that the price of shares is based upon demand and not the asset value of the holdings that make up the fund. CEFs can be actively managed, and therefore can and will have all kinds of strategies and unique investing practices in place. That means that holdings of a CEF are often unknown to the investing public at all times. That being the case, CEFs will often trade in a wide range when compared to their NAV. CEFs that focus on MLPs will often time trade well above the NAV of the fund. The risk is that if one is not careful, they might find themselves paying huge premiums for shares that could at any point in time snap back to near par value. This will make for outsized losses -- even though the overall fund's business practices might be sound.
To maximize yields to shareholders, CEFs will issue preferred shares or even borrow more money and take on debt. This is a standard business practice in the industry, and if used correctly it can really increase the funds yield to shareholders. Needless to say, if the leverage is overdone it can expose the fund and its share price to risk. For example, changes in interest rates and market conditions will make these highly leveraged funds more volatile in share price. When we turn our attention to the MLP CEFs we find that these funds will often times leverage themselves to fairly high levels, which might be considered a bit excessive in some cases.
Management Fees
Companies that run CEFs don’t do it for free. These companies will charge management fees for their expenses to operate the funds. That being the case, a fund that is actively managed or is highly leveraged will incur some pretty good sized management fees. Our MLP closed end funds are no exception here, and will often sport some fees that make investors think twice. Needless to say, outsized management fees will definitely make their presence felt against the returns to the shareholders.
Payouts and Return of Capital (ROC)
Yield percentages are often times what will attract income investors. The secret is to see what makes up the yield, or what types of funds are generating the yield. What one wants to see is that the source of the yields is derived from ordinary income or even capital gains. Seeing those types of sources suggests that management is doing their job well. If your yields are coming from a return of capital (ROC) then there might be some concern. The problem could be that the fund has not generated enough earnings to cover distributions, so management makes a decision to return the investment capital instead. This makes the yield seem competitive, but the fund might just be cannibalizing itself as it is failing at its mission. Not all ROC is necessary bad, but it is a clue that something might not be working as it should. Our MLP CEFs will also need to be analyzed to determine where the yield is coming from. The results might surprise you in the end.
These four risks are some of the more predominate ones that any income investor should consider when choosing a CEF that focuses on MLPs. Obviously there are other risks, but these four are a great place to start. When one looks at the MLP Closed End Funds table below, they might find some interesting characteristics. Below are seven of the most popular CEFs that have a major focus on MLPs. It should be known that this article is not rating these CEFs as a buy or sell. Its sole focus is to show retail investors that a pure focus on yield is not enough research when it comes to buying MLP CEFs. These particular CEFs carry their own set of risks that are unique to the industry. If one is able to manage these risks and understand the concepts of what makes up these funds, then they might make perfectly viable investments for any income investor.
Ticker Yield Leverage
Kayne Anderson KYN 7.09% 47.29% 4.15% 13.78% 100% $2.07B
ClearBridge CEM 6.75% 22.25% 0.70% 1.59% 100% $1.36B
Cushing MLP SRV 9.72% 42.25% 3.06% 27.72% 100% $437M
Tortoise Energy TYG 5.97% 36.08% 3.31% 14.95% 100% $1.36B
Nuveen Energy JMF 7.21% 22.34% NEW 5.92% NEW $503M
Tortoise Energy Cap TYY 6.32% 30.09% 5.37% 4.04% 100% $675M
Fid.Claymore FMO 7.01% 28.67% 2.10% 2.43% 100% $662M

In conclusion, it is not hard to see some issues that one needs to investigate before investing in the above funds. Finally, it should be stated that the ROC percentages were calculated based upon the last three distributions by the fund. This percentage can and will change as future distributions are made.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.