New MLP Funds That Aim to Lower Tax Bills / A new generation of popular master-limited-partnership funds hopes to skirt unfavorable tax treatment—but investors should be careful.

Murray Coleman for the Wall St Journal writes; Investors are flocking into funds specializing in dividend-rich master limited partnerships.

That could prove onerous come tax time. By some estimates, mutual funds and exchange-traded funds that load up on MLPs—publicly traded pipeline operators and energy-service firms—can lose as much as 39% of their returns to federal and state corporate taxes alone.

As a result, fund firms have been introducing a second generation of MLP products that carry less of a tax drag.

MLP mutual funds and exchange-traded products have attracted $9.6 billion in inflows this year through September. That already tops last year’s $7 billion of net new money entering the category, according to investment-research firm Morningstar. At its current pace, positive flows into the group stand to set a new annual all-time high.

The funds offer strong returns and yields—income divided by share price—averaging around 5.2%. For example, the $1.3 billion UBS E-Tracs Alerian MLP Infrastructure exchange-traded note had an average annual gain of 15.6% over the past three years through Thursday. That was good enough to keep pace with the lower-yielding broader market, as represented by the SPDR S&P 500 ETF.

By contrast, the largest ETF of its kind by assets is the ALPS Alerian MLP ETF. The $6.9 billion fund has lagged behind its ETN rival by more than five percentage points over the past three years.

Both products track the same benchmark, though the UBS ETN isn’t structured like a traditional fund, says Morningstar analyst Abby Woodham. Instead, it is an unsecured debt product designed to replicate the return of an MLP index. This feature typically allows such vehicles to be less hampered by tax liabilities, she says, but investors are exposed to the credit risk of the issuer.

Since it doesn’t technically own securities, the UBS ETN is able to avoid paying corporate income taxes, which can represent a much bigger hit than capital-gains taxes. A typical mutual fund or ETF with 25% or more of its assets in MLPs can’t skirt that burden.

In order to sidestep such tax issues, newer ETFs and mutual funds are aiming to stay below that 25% threshold for holding MLPs, Ms. Woodham says.

Two ETFs filling that bill are the actively managed First Trust North American Energy Infrastructure Fund and the index-tracking Global X MLP & Energy Infrastructure ETF. Others are on the way, Ms. Woodham says.

But investors shouldn’t confuse the newfangled products with their predecessors, says Michael McClary, chief investment officer at the $4.75 billion wealth-management arm of ValMark Securities in Akron, Ohio.

“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 isn’t unusual for energy-focused ETFs and mutual funds to use a smattering of MLPs, says Ron Rowland, president of Capital Cities Asset Management, an asset-allocation consultant to other advisers. “This isn’t anything new—these are little more than what have been traditionally known as diversified energy funds,” he says.

Broader-based energy funds don’t usually own the same types of MLP “affiliates,” says Austin Poirier, a senior investment adviser at Ballentine Partners in Waltham, Mass., which manages $4.5 billion. That is an important distinction for investors aiming for more-diversified energy exposure, he points out, since the new MLP funds tend to focus on total returns rather than just reaching for yield.

Caveats do exist. For one, the new crop of MLP ETFs and mutual funds can be expected to produce annual yields one to two percentage points less than conventional MLP funds, Morningstar’s Ms. Woodham says. On the other hand, they typically come with less administrative overhead and charge much lower management fees.

Meanwhile, the Internal Revenue Service is looking into the tax treatment of indirect holdings of MLP subsidiaries, a development that Mr. Poirier cautions could result in the new funds being forced to make significant shifts in existing portfolios.

“We’re leaning to using these new funds, at least to some degree,” he says, “although we’d like to see how the market evolves and how the IRS reacts in early December before making any specific decisions.”