There's a lot to like about Master Limited Partnerships, or MLPs. These entities typically own really boring assets like pipelines, oil storage terminals or processing plants, and lease the capacity of these assets to others for a fixed rate. That provides the MLP with a very steady stream of income, which it promptly sends back to investors via very generous cash distributions.
That being said, there are a couple of downsides to MLPs. Because of their tax structure, they send investors a Schedule K-1 each year, which leads to some extra paperwork come tax time. Further, some investors have found that they can't own an MLP in their IRA because of something called unrelated business taxable income, or UBTI. These issues can cause investors to simply pass on these entities.
However, there is a way around these downsides. Closed-end funds that own MLPs provides investors access to a diversified basket of top MLPs without the tax headaches or IRA restrictions.
What is a closed-end fund?
A closed-end fund is kind of like a mutual fund and exchange traded fund, or ETF, all rolled up into one. They have the tradability of an ETF but are more actively managed, like a mutual fund. However, a closed-end fund differs from a mutual fund in that it raises capital from the public markets via an IPO as opposed to simply issuing new shares whenever new investors want into the fund.
Another way to look at a closed-end fund is to think of a company that only owns the stocks or units of other companies. All of its income is generated from its earnings from owning these equity stakes in other public companies instead of its own business operations.
How to use closed-end funds to energize your retirement portfolio
One of the more compelling ways an investor can use a closed-end fund is by investing in an energy-related fund that focuses on MLPs. Funds like Tortoise Energy Infrastructure Corp (NYSE:TYG) and Kayne Anderson MLP Investment Co. (NYSE:KYN) make it easy for investors to invest in MLPs through IRAs, as both offer the simplicity of a Form 1099 and have no UBTI.
Tortoise focuses on MLPs that transport, gather, process, or store natural gas, NGLs, crude oil, and refined petroleum products, which provides investors with a lot of diversification. Further, the company actively manages the fund to provide its investors with a bit more upside to better opportunities. For example, as of the end of February, the fund's two largest holdings were Magellan Midstream Partners, L.P. (NYSE:MMP) and Plains All American Pipeline L.P. (NYSE:PAA) at 9.4% and 9.2% of the fund's value, respectively. While both are large MLPs, neither is the largest in the sector. Instead, both are leading positions in the fund because of their strong total return potential. Moreover, the fund's top 10 holding represent 60% of its investment securities, as the fund invests the bulk of its capital in its best ideas.
Kayne Anderson has a similar philosophy of seeking the best total returns, however, it takes a slighly different path to get there. Magellan Midstream, for example, isn't one of its top 10 holdings. Instead, Kayne Anderson's largest holdings are Kinder Morgan Inc (NYSE:KMI), which, incidentally, isn't an MLP, and Enterprise Products Partners L.P. (NYSE:EPD). These are two of the largest midstream companies in the country, and as such, are not a surprise to find at the top of Kayne Anderson's list, which tends to invest more of its capital in the top companies by size.
Not everything is perfect
While closed-end funds have a lot to offer, they are not without their downside. Both charge investors management fees, which are taken out of the income from the MLP distributions. Kayne Anderson, for example, has typically charged a 2.4% management fee each year, which reduces investors returns. Meanwhile, Tortoise has a fee based on the asset value of the portfolio and was recently 0.92%.
On top of that, both use leverage to juice returns, which adds to risk as MLPs typically employ a lot of leverage already because of the asset-heavy nature of their business. Right now, Tortoise's leverage is 23.5% as a percentage of total assets, with a goal of up to 25% leverage, while Kayne Anderson's leverage is a bit higher, at roughly 30% of total assets. That leverage could work against investors in a down market as it will act as a weight on returns.
Overall, closed-end funds really do have a lot to offer, as they provide investors with an easy option to put MLP-type income in their retirement accounts. Further, because these entities are managed, they offer diversification and a bit more upside potential than simply buying and holding a large MLP. While these funds aren't perfect, they do offer investors a nice option to own MLPs in an IRA.