December 5, 2010

Why Closed-End Funds Provide Good Entrée into MLPs

Closed-end funds in the U.S. equity space still trade at attractive discounts

There has been a recent surge in popularity for Master Limited Partnerships as an investment option. Closed-end funds have become a significant player in this market.

Known as MLPs, these securities represent a stock market niche with a total market capitalization of $200 billion. MLPs own energy infrastructure assets and rent those assets to energy producers. For instance, a natural gas producer pays the MLP to use its transportation pipeline. The tolls are subsequently distributed to limited partners without company-level taxation. 

Yield is what makes MLP’s attractivefor most investors.  The current yield on MLP shares is 6.4%, though 12 months ago the yield was over 7.8%. In addition, MLPs are gaining attention as an alternative asset class that can provide diversification. Juicy yields combined with phenomenal performance often create potential investor frenzy.

As of November 30, the average premium on MLP closed-end funds was 4.4%.  Demand for MLP closed-end funds is growing because many investors prefer to own MLP shares through closed-end funds to avoid the tax headaches associated with direct MLP ownership.

There are 12 MLP closed-end funds with total net assets of $7.9 billion.  Meanwhile, MLP closed-end funds have raised nearly $3 billion this year—a huge issuance given that total net assets for MLP closed-end funds was only $4 billion at Dec. 31, 2009.

There have been two IPOs and eight secondary offerings this year by existing MLP closed-end funds, and we expect more to come through the pipeline. In addition to the closed-end funds, access to exposure to MLPs has also been introduced in various other structures such as open-end funds, ETNs and ETFs. For example, the family of SteelPath MLP open-end funds and the Alerian MLP ETF were launched this year and were the first of their kind.

Amid this popularity surge, the overall dynamic for the MLP market gives us a bit of pause due to the flood of money into MLPs in a short period of time, possibly resulting with investors not getting compensated for the inherent risks within the asset class. 

In the overall closed-end fund market the RiverNorth Closed-End Fund Index was down -0.35% in November and is up 14.49% year-to-date.  Since the end of the third quarter discounts have widened out 0.08% and currently stand at -1.66% on average.

Despite the recent surge in performance, closed-end funds in the U.S. equity space are still at attractive discounts, with an average discount of approximately  -8.1%.  On the other end, fixed income is trading at narrow discounts or premiums, as the markets’ search for yield continues.


Patrick W. Galley is the chief investment officer of RiverNorth Capital Management, LLC, an investment management firm based in Chicago.  The firm specializes in quantitative and qualitative closed-end fund trading strategies and is the investment adviser to RiverNorth Funds.   

Reprints Discuss this story
This is where the comments go.