In a comparison between exchange-traded funds and closed-end funds, the low expenses and low portfolio turnover features of an ETF provides a built-in advantage over a comparable CEF with a typically much higher annual expense and tax consequences from capital gains distributions. You have probably seen the statistics and articles stating that an index stock fund on average outperforms 2/3rds, or 75% or 90% some other one-sided number of actively managed funds. However, when it comes to running an ETF based on an MLP index, the rules shift, putting the chances for out-performance into the closed-end fund camp.
Income Pass-Through Doesn't Work Twice
A company organized as a master limited partnership does not pay corporate income taxes, and profits are reported to limited partnership investors to include on their personal tax returns. For many MLPs, there are sufficient tax write-offs so that investor will have little or no taxable income to claim from MLP holding. Distributions paid by an MLP classify as a return of capital and are not taxable income. ROC payments reduce the cost basis in an investment.
A fund typically registers as a regulated investment company, which allows the fund to also not pay income taxes as long as all portfolio earnings and realized capital gains are passed through to investors. The tax characteristics of the income earned by the fund's portfolio passes along with the fund distributions.
However, for an MLP focused fund, to maintain regulated investment company status, the holdings of MLP type investments must be less that 25% of the fund's portfolio value. As a result, and ETF, mutual fund, or closed-end fund that focuses on MLP investing must organize as a corporation and pay corporate income taxes on the earnings produced from the fund's investments.
Paying Taxes Hurts
An ETF or other MLP focused fund organized as a corporation realizes the consequences of functioning a taxable entity in two ways. When the fund earns taxable K-1 income or sells holdings for a taxable gain, taxes must be paid, and those payments increase the total expenses reported by the fund. For example the current reported expenses for the largest MLP ETF, the ALPS Alerian MLP ETF (NYSEARCA:AMLP) total 4.85%, with a 0.85% management fee and much of the other 4% will be taxes paid. In addition, an MLP fund will also track its deferred income tax expense -- taxes that would be due when currently held investments are sold. The deferred income tax amount is included in the fund's calculated net asset value. This means the reported NAV will lag the actual investment gains as the fund's MLP positions go up in value.
The effects of the corporate structure and owning MLPs can be seen in the returns posted by ALMP compared to the benchmark Alerian MLP Infrastructure Index. For the 3-year period which ended on January 31, 2014, the index recorded an average annual total return of 15.62%. However, over the same period, the Alerian MLP ETF only earned 9.52% annually for investors. This means close to 40% of the MLP index return was sucked away by the expenses and tax liabilities of the ETF structure.
Closed-End Fund Advantages
Compared to an ETF, which must hold securities to mirror a selected index, a closed-end fund has a more wide open charter concerning investment choices and holdings. One feature that helps an MLP CEF is the ability to use moderate leverage in the portfolio. With the usual 20% to 30% leverage used by a CEF, the value of the portfolio holdings is larger than the equity assets of the fund, allowing the extra earnings to offset some of the tax bite on an NAV per share basis.
As an additional hedge against corporation taxes, you can often find CEF shares trading at a discount to the NAV. Today - 2/25/14 - 22 of the 26 MLP CEFs tracked by MLPData were priced at a discount to NAV and 13 had discounts greater than 5%. Buying a CEF at a discount adds another layer of leverage to your return and yield potential. Almost every CEF will trade at a discount at different points in time, so the patient investor can either wait for a favorite fund to move to a discount or find an alternative that is already trading for less than NAV.
MLP CEFs to Look at Now
Here is a short list of MLP focused closed-end funds that are near the top of the list for NAV discounts and have produced above average, two-year total returns.
Tortoise Pipeline & Energy Fund (NYSE:TTP) currently carries the largest discount to NAV at 13.4%. Over the last two years, TTP has produced an average annual return of 13.8% and sports a current distribution yield of 5.7%. The distribution rate has been level since the fund's inception in October 2011.
Kayne Anderson Midstream/Energy Fund (NYSE:KMF) has a share price trading at an 11% discount to NAV. Over the last two years, KMF produced a 19.3% average annual return and the fund currently yields 5.5%. Historically, this fund has paid on a different dividend schedule, with payouts in the 2nd and 3rd quarters and a double dose in the 4th quarter. The total annual distribution has been growing by about 5% per year.
First Trust Energy Infrastructure Fund (NYSE:FIF) shares are currently at a 9.9% discount to NAV. The fund returned 10.83% annualized over the last two years. The fund's current yield is 6.4% with monthly distributions.
These funds provide investment exposure to the MLP universe without the hassle of K-1 forms. Buying superior returns - compared to an ETF - at a discount helps closed-end funds make up for the internal tax challenges an MLP fund faces.
New Unique CEF Investing Feature: MLPData now includes Price to NAV premium or discount changes on the fly. Look under the Find Funds top menu bar tab to start tracking share price discounts and premiums on the full list of MLP CEFs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.