Special Energy Funds Triple Treasury Yields

NEW YORK ( TheStreet) -- Funds that invest in master limited partnerships returned more than 80% last year and added another 10% so far in 2010, a striking result when many fund categories have sunk into the red. Can the good news continue? Perhaps.

MLPs, which typically invest in energy pipelines and other vital infrastructure, are reporting solid revenues. But short-term investors should be cautious. Some funds now sell for a premium above the value of their net assets.

MLPs have been attracting attention because of their yields. Many funds currently distribute yields of more than 7%, an attractive payout at a time utility stocks yield less than 4% and 10-year Treasuries yield 2.75%. Most MLPs have proved to be rock-solid income producers, paying out steady distributions year after year.

The income tends to be reliable. A typical partnership buries a pipeline deep underground and charges oil or gas companies to use it. The fees are based on the volume of material that travels through the system -- not on the price of energy. Pipeline users often sign contracts for 10 years or longer and agree to increase their fees along with inflation.

Under the rules, an MLP need not pay corporate taxes as long as it distributes most income to shareholders who must file returns. However, the IRS treats most distributions as a return of capital. So investors who get 7% distributions this year may avoid paying taxes next April 15 -- and they may be able to defer paying the IRS for years.

Despite the obvious appeal of MLPs, they have been a niche product partly because of their paperwork requirements. Owners of the stocks must file partnership tax returns, and they may need to file tax returns in every state where the partnership does business. Since some pipelines run through more than a dozen states, the paperwork can be enormous. As a result, most owners of shares in MLPs have been wealthy individuals from energy states.

In recent years, some closed-end funds began investing in MLPs. The funds enable shareholders to collect income from the partnerships and avoid most of the paperwork. During the downturn of 2008, the funds sank along with the stock market, then rocketed last year as investors sought yield. Seeing the big returns and rich yields, several companies have launched closed-end funds recently. Newcomers include ClearBridge Energy MLP ( CEM) and Tortoise MLP Fund ( NTG).

The closed-end funds issue limited numbers of shares that trade on stock exchanges. Lately, the shares have been trading at premiums to the value of the assets in the fund portfolios. For example, Fiduciary/Claymore MLP Opportunity Fund ( FMO) sells at a 10% premium. So investors must pay about $1.10 for a dollar's worth of assets.

To avoid the premiums, consider one of three open-end mutual funds launched in March by SteelPath Fund Advisors. SteelPath MLP Select 40 has a distribution yield of 6.6% and holds a cross-section of 40 MLPs. The fund aims to provide broad exposure to the industry. Investors seeking extra income can consider SteelPath MLP Income Fund, which yields 7.6% and focuses on large MLPs with high payouts. SteelPath MLP Alpha yields 6.6% and aims to hold undervalued securities that can deliver above-average total returns.

SteelPath portfolio manager Gabriel Hammond particularly likes MLPs that can grow through construction or increased traffic. A favorite holding is Holly Energy Partners ( HEP), which operates pipelines that transport gasoline, jet fuel and heating oil in the Southwest. "The company can expand because demand in its territory is increasing," Hammond says.

He also likes Inergy ( NRGY), which stores natural gas near New York City. Demand for the partnership is strong because storage facilities are in short supply in the Northeast, Hammond says.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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