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Understanding Distributions From MLP-Focused CEFs

Master limited partnerships' pass-through returns of capital cause two issues.

Mike Taggart, CFA, 10/04/2013

A version of this article was first published on July 2, 2010.

When it comes to investing, I believe that complexity often leads to opportunity. If a security is complex or a company's story is complex, many investors simply avoid the hassle of figuring it out, creating a market inefficiency. Small-cap stocks face this all the time: often, the companies behind these stocks have no analyst coverage, have no means to get their stories heard, and have attractive valuations. For investors who seek such stocks and are willing to do the legwork, the financial rewards can be considerable.

The same holds true with closed-end funds. These are, relative to mutual funds and ETFs, complex creatures for investors and advisors to figure out. Items such as discounts, leverage, and return of capital have to be learned. It takes a investment of time and effort. Some investors commit to figuring out the complexity and go on to reap the rewards of CEF investing, which typically includes higher income relative to mutual fund and ETF investing.

Master limited partnerships, or MLPs, are also complex securities. The nature of energy-focused MLPs is fairly straightforward, but tax filing and learning about the unique return-of-capital distribution characteristics make some investors wary of them. However, those who take the time to get comfortable with MLPs typically swear by their investment benefits.

By any measure, CEFs invested in MLPs are a complex security. One might think investors would shun such securities, but the opposite is true. In 2013, three new MLP-focused CEFs came to market, raising over $2.5 billion in gross proceeds; that's up from six such funds that raised $2.4 billion in gross proceeds in 2012 and five such funds that raised $1.7 billion in 2011. For these funds to have been launched--and new MLP-focused mutual funds and ETFs have not been absent from the mix--it's clear investor demand has increased.

Like any investment, it's important to understand the complexities before committing your capital. A recent discussion with industry executives highlighted once again that many CEF investors seem to misunderstand the nature of MLP-focused CEFs' distributions. That discussion brought to mind the following article, a version of which was originally published three years ago:

Closed-end funds that invest in MLPs have a different type of return of capital. In fact, the MLP return-of-capital subject is so distinctive that it requires its own explanatory article. Not only does the return of capital for MLP CEFs affect the distribution source, it also affects the net asset value.

Let's start at the beginning. MLPs are, indeed, partnerships. The distinction seems slight, but it's not. When you own a share of a corporation, you own a portion of the equity. When you own a share of a partnership, you actually own a unit of the partnership's business interests. Partnership units are not taxed at the business level but at the investor, or partner, level. The key to understanding MLP taxation--and related tax accounting concepts, such as return of capital--is that taxable income and MLP cash distributions are two separate things. Under accounting rules, an MLP's pipelines (most MLPs own and operate energy pipelines) are depreciated as an expense. Thus, because of accounting, taxable income is typically less than actual cash flow generation for MLPs. That is to say, the amount of cash available for distribution is usually far greater than the amount recorded as taxable income.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.

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