The tax burden of owning a fund investing in pipeline operators and related service providers can be onerous. By some estimates, funds that load up on such fare can lose up to 39% of their returns to federal and state corporate taxes.
As a result, fund sponsors have been developing new ways to play MLPs with a so-called "second-generation" of ETFs that carry less of a tax drag.
This year, MLP exchange-traded products and mutual funds have attracted $9.6 billion in inflows through September. That already tops last year's $7 billion of net new money entering the category, according to investment researcher Morningstar.
"We're kind of wary of next-generation MLP ETFs and mutual funds. The big concern is that people get into these funds thinking they're investing in MLPs, but when they take a closer look, these really aren't the same animals," says Michael McClary, chief investment officer at ValMark Advisers with $4.75 billion in assets.
The allure of MLP funds are juicy yields, currently averaging around 5.2%. The funds have also kept pace with the broader market in providing attractive total returns. For example, a popular exchange-traded note, the $1.3 billion UBS E-Tracs Alerian MLP Infrastructure ETN, had gained an average annual 15.9% over the past three years, through Monday. That was nearly half a percentage point better than the broader market as represented by the SPDR S&P 500 ETF.
By contrast, the largest ETF of its kind by assets is the $7 billion ALPS Alerian MLP ETF. It has lagged by more than five percentage points its ETN rival over that same period. Both track the same benchmarks, says Morningstar analyst Abby Woodham, but the ETN is an unsecured debt instrument.
Since it doesn't technically own securities, the ETN is taxed differently than a typical mutual fund or ETF that holds 25% or more of its assets in MLPs. In those cases, the government mandates that a fund must pay corporate taxes, which carry a much bigger hit than capital-gains taxes.
The after-tax result is severely crimping returns of many first-generation MLP ETFs, Ms. Woodham says, resulting in the second generation of ETFs that keep direct ownership in MLP partnerships below that 25% tax threshold.
Two ETFs filling that bill are already out--the actively managed First Trust North American Energy Infrastructure ETF and the index-tracking Global X MLP & Energy Infrastructure ETF. Others are on the way, says Ms. Woodham.
But investors should not confuse the new versions with their predecessors, warns ValMark's Mr. McClary. "The new funds coming to market aren't the same as traditional MLPs--they're branching into similar, but different, affiliated industries," he says.
It's not unusual for hybrid funds at times to use a smattering of MLPs, observes Ron Rowland, president at Capital Cities Asset Management, an asset-allocation consultant to other advisers. "This isn't anything new--these are little more than what has been traditionally known as diversified energy funds," he says.
Most energy funds taking a broader mandate hold little if any corporate pipeline operators, points out Austin Poirier, a senior investment adviser at Ballentine Partners with $4.5 billion in assets.
"There are a lot more ways to play the boom in U.S. energy markets than just MLP pipeline operators or big energy exploration and production companies," he says.
Caveats do exist. For one, funds with traditional corporate holdings can be expected to produce 1-2% a year less in yield, says Morningstar's Ms. Woodham. On the other hand, they usually should come with less administrative overhead and charge much lower management fees.
In early August, the Internal Revenue Service challenged indirect holdings of MLP subsidiaries, according to The Wall Street Journal.
"We're leaning to using these new funds, at least to some degree, although we'd like to see how the market evolves and how the IRS reacts in early December before making any specific decisions," Mr. Poirier says.
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