A 21% Yield You Should Avoid

Low interest rates have made investment income scarce, but the intrepid and indiscriminate yield chaser can still collect a cool 21% per year in one increasingly popular energy fund.

All it takes is not caring where the money comes from, how long it can keep coming at the current rate or how big a bite taxes will take eventually.

Because, let’s face it, those are all problems for another day. Right now you get to collect the 21% and brag about it at cocktail parties and on message boards.

The fund in question is InfraCap MLP ETF (AMZA). An actively managed ETF, it uses leverage, short sales and option income to juice returns. Even so, after-tax capital gains and investment income covered only a little more than half of the distributions to AMZA holders for the six-month period through April.

AMZA’s semi-annual report claims “the fund uses a cash flow-based distribution approach based on the fund’s net cash flow received from portfolio investments.” But the risk section of the prospectus  clarifies that “shareholders who periodically receive the payment of dividends or other distributions consisting of a return of capital may be under the impression that they are receiving net profits from the fund when, in fact, they are not. You should not assume that the source of the distributions is from the net profits of the fund.”

And, in fact, AMZA has made similar distributions since inception in late 2014 despite running up investment losses of nearly a third of its net asset value in its first full fiscal year.

That was a byproduct of the energy crash and the resulting selling of the midstream master limited partnerships (MLPs) accounting for the bulk of AMZA’s portfolio.

But the underlying problem isn’t going away. As a corporation taxed at the top 35% corporate income tax rate, AMZA has begun accumulating a deferred income tax liability, currently at a manageable $7 million. This will grow with unrealized capital gains, and when some of those are realized down the road the fund will face an additional tax hit from the depreciation recapture rule allowing the government to collect income taxes on past depreciation allowances.

As the prospectus notes, “when deductions are recaptured, distributions to the fund’s shareholders may be taxable, even though the shareholders at the time of the distribution might not have held shares in the fund at the time the deductions were taken by the fund, and even though the fund’s shareholders at the time of the distribution will not have corresponding economic gain on their shares at the time of the distribution.”

Translation: those collecting the 21% annualized yield right now are doing so in part at the expense of future holders who will be liable for the taxes now getting deferred. But AMZA didn’t fully cover its distributions over the six months through April even excluding those deferred taxes.

None of this is likely to matter much unless and until MLPs hit another particularly rough patch. Until that happens, unrealized gains can continue to finance the distributions. And so long as that remains the case the huge yield will continue to attract short-term speculators as well as unsophisticated investors.

In fact, between November and April AMZA’s net assets trebled to $368 million. The fund manager has become a pundit sought out by the likes of Barrons. A member of CNBC’s Fast Money crew was recruited for AMZA’s advisory board. The fund doesn’t miss many marketing tricks.

But if the investment inflows were to reverse, AMZA as well as its shareholders would face a much bigger tax hit. And if the 21% yield is still around by then it likely would be history soon thereafter.

The bottom line here is that the concentrated midstream investments in AMZA’s portfolio currently have an aggregated annual yield of around 8%, and leverage, call writing and short sales can boost returns by a few more percentage points. But that’s before reckoning with the long-term tax expense and the fund’s 1.71% expense ratio.

Even the passive, index-tracking ETFs invested in MLPs tend to dramatically underperform their target index over time because of the taxes they owe on MLP distributions. MLP investors are much better off in exchange-traded notes, which are not taxed directly, even though ETN distributions lack the tax deferral benefits of direct MLP ownership.

Join us at Income Millionaire for recommendations on high-yielding MLPs that are likely to sustain their payouts.