The Federal Reserve’s continuing trend of quantitative easing in recent years has injected substantial liquidity into capital markets, forcing yields on traditional asset classes to all-time lows. As a result, many investors have become increasingly interested in once relatively obscure, master limited partnerships. Historically, MLPs have provided low correlations to other asset classes as well as compelling yields.

MLPs typically operate in the midstream energy sector. These partnerships primarily own and operate the vast networks of pipelines through which oil and natural gas are delivered across the country. Many MLPs also own the processing and storage facilities needed to bring these valuable commodities to market. MLPs collect fees based on the volume of product that passes through their pipelines. Fees are negotiated as part of long-term contracts with oil and gas companies, often with inflation hedges built in. As a result, MLP revenues tend to remain relatively stable.

The case for utilizing MLPs as part of a greater asset allocation is two-fold. First, MLPs tend to offer very attractive investment yields. Due to their partnership structure, MLPs are not taxed at the entity level. Instead, most of their income must be passed through to shareholders, with the majority of distributions considered a return of capital. Unlike divided distributions, return-of-capital distributions reduce the cost basis of the investment, and taxes are deferred until shares are sold.

MLPs may also add value as a diversifier. They offer access to the energy sector while avoiding much of the volatility inherent in investing in oil and gas directly. Although MLPs may still experience an increase in correlation to the general markets during times of distress, they tend to be less stock-like than other income producing assets due to the long-term nature of their underlying contracts.

Direct investment in MLPs is not without drawbacks. The MLP industry is relatively fragmented, with most MLPs focusing their investments regionally. This can make it extremely difficult for investors to effectively evaluate risk and select appropriate positions. Additionally, MLPs tend to be more complex at tax time. Tax reporting is completed via Form K-1 rather than the more timely and easily managed 1099. They may also generate considerable unrelated business taxable income, or UBTI, which can further complicate an investor’s tax picture, especially if the MLP is held in a retirement account.

Until recently, investors had no choice but to invest in MLPs directly. Now, newly created MLP-focused mutual funds and ETFs may be able to provide a better alternative. These investments strive to provide access to the many benefits of MLPs, including yield, appreciation and diversification in a more investor-friendly structure. In this format, the mutual fund or ETF serves as a shareholder in multiple MLPs and is afforded the benefits of direct MLP investment. Individual investors can then purchase shares of the mutual fund, or ETF, gaining access to the underlying bucket of MLPs. By utilizing a mutual fund or ETF, investors may be able to diversify more broadly among MLPs, reducing the risks associated with individual positions. MLP mutual funds and ETFs also provide daily liquidity and simplified 1099 tax reporting.

It is important to note that MLP mutual funds and ETFs are not without faults. Any open-end fund that invests more than 25 percent of its portfolio in MLPs is generally organized as C-Corp and is subject to corporate income taxes. These taxes are paid at the fund level and may dampen performance, compared to direct investments in MLPs. Although not perfect, new MLP mutual funds and ETFs may prove to be an attractive option for investors looking for yield exposure and additional diversification.