Posted by on May 23, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  May 20, 2016 12:19 pm ET

A type of investment that is up 11.5% so far this year, often pays hefty income and is trading at a discount might sound like perfection.

Instead, the quirky funds producing these results are a reminder of why skepticism is the cardinal investing virtue.

Two or three years ago, closed-end funds holding master limited partnerships were so popular that investors sometimes had to pay $1.20 for every dollar in assets. Today, on average, the same dollar’s worth of energy-related investments is available for 95 cents — but that still doesn’t make these funds a bargain, even though their underlying holdings are also much cheaper than they used to be.

Closed-end funds, like mutual funds, pool money from many different investors to buy an investment portfolio. Unlike conventional funds, however, closed-end funds don’t create new shares when investors want to buy more. They issue a finite number of shares, which trade on a stock exchange.

When they’re in high demand, the shares trade at a “premium,” or more than the value of the underlying portfolio. When they’re not, they fall to a discount, or less than the fund’s holdings are worth.

That can make such funds seem tempting at a time like this, with energy partnerships almost halfway down from their peak prices. Although these funds offer the convenience and income that many investors find attractive, they also offer unusual risks, costs and tax wrinkles that often outweigh those advantages.

All the closed-end MLP funds are “leveraged,” borrowing money to juice their returns. On average, of every $3 they manage, $1 is borrowed. That increases the risk that these funds will underperform if interest rates rise, as more-attractive opportunities become available at the new higher rates.

The funds are also expensive. The average management fee at the 26 closed-end MLP funds tracked by Morningstar is 1.37% annually, or $137 per $10,000 invested. You could buy any of the underlying energy partnerships directly and pay no additional management fee, although you might have to navigate some Byzantine tax consequences.

All told, these funds raised about $21.5 billion in stock and bond offerings, according to data from Morningstar and FactSet Research Systems. Only about $13.6 billion remains. That’s partly because investors took much of their money out in the form of dividends and partly because banks and brokers harvested nearly $1 billion in underwriting fees. Above all, the average closed-end MLP fund lost 42.7% last year, shortly after energy stocks peaked in 2014 and gushers of new money poured in.

Now that energy stocks are much cheaper and the shares of the closed-end funds themselves are trading at discounts to the value of their underlying portfolios, the managers could buy back shares of their funds by the barrel.

But 14 of the 26 funds tracked by Morningstar have more shares outstanding today than they did a year earlier, according to their latest regulatory filings. At most of the others, the total number of shares hasn’t budged. Although closed-end funds don’t sell new shares every day as mutual funds do, they can create more stock in secondary offerings, while some investors also choose to reinvest their dividends in additional shares.

Two of the four closed-end MLP funds run by KA Fund Advisors, a Houston-based unit of Kayne Anderson Capital Advisors, bought back about $24 million in stock in 2014 when shares were at nearly a 10% discount.

“If we can buy our own stock at an 8% discount, that’s a healthy investment opportunity,” says Kevin McCarthy, the funds’ chief executive. But KA isn’t buying back shares at today’s narrower markdowns.

Historically, closed-end funds trading at discounts of 10% to 20% have offered attractive future returns. But at today’s average discount of only 5%, they are pale bargains at best.

Finally, such funds take one of the greatest assets of energy partnerships — tax efficiency — and turn it into a liability. Often, the cash distributed to investors who hold energy partnerships directly, rather than through a fund, is sheltered by depreciation and other tax breaks. Treated as return of capital, that income may be tax-deferred for years or even decades.

Inside closed-end funds, however, the same income can become taxable at up to 35%, shriveling the yield to investors.

Back in their 2013-2014 heyday, many brokers sold closed-end MLP funds as high-yielding “bond equivalents” that supposedly were less risky than conventional stocks.

As the late financial analyst Raymond DeVoe said, “More money has been lost reaching for yield than at the point of a gun.” No matter what kind of investment someone is flogging, you should always remember that high yield and low risk are like oil and water.

Source: The Wall Street Journal