Not every closed-end fund that promises one-stop exposure to master limited partnerships (MLP) is created equal–these investment vehicles don’t perform that way, either.

Readers seeking our take on the universe of MLP-focused funds should consult the Fund Ratings table, which contains a number of key data points and our comments on the merits of the fund’s strategy, management and/or performance.

First-Half Lessons

The year began with a surge of optimism. Energy-related MLPs, particularly those with exposure to booming demand for new midstream infrastructure, benefited from frenzied buying activity in the stock market. Meanwhile, the group’s long-term growth prospects appear sanguine.

The combination of ready access to inexpensive capital and the pressing need for additional takeaway capacity to support robust drilling activity in shale plays promised to fuel distribution growth in coming years. Meanwhile, mergers and acquisitions also surged, as upstream MLPs sought to purchase underpriced acreage and midstream MLPs vied for pipeline assets.

Then commodity prices began to tumble. Natural gas prices, which were already weakened by the glut of production from prolific shale gas plays, sank even further after the no-show winter of 2011-12 sapped demand and increased the volume of gas in storage to record highs. With producers beating a hasty retreat from gas-focused basins, critics questioned the demand for additional midstream capacity in these plays. Meanwhile, MLPs that own natural-gas storage capacity–a business line that depends on seasonal price differentials–were absolutely mauled.

By May, oil prices had started to slip, undone by rising concerns about global economic growth and Europe’s ongoing sovereign-debt crisis. The price of natural gas liquids (NGL)–a group of hydrocarbons that tend to track oil prices–also tumbled precipitously.

Although many MLPs limit their sensitivity to oil and gas prices through extensive hedging programs, a lack of liquidity has hampered efforts to protect cash flows against weak NGL prices. Across the board, energy-focused MLPs have felt the pinch from the recent decline in NGL prices.

We addressed these concerns in MLPs and Energy Prices and MLPs and the Winter of Discontent, concluding that the bulk of our Portfolio holdings were relatively well-insulated from the recent slide in commodity prices.

Throughout this period of uncertainty, we’ve emphasized that our favorite Portfolio holdings would recover from these temporary hiccups as long as their underlying businesses continued to support their distributions.  

Several of our top picks sold off earlier this summer, only to soar again in July. Conservative Portfolio holding Enterprise Products Partners LP (NYSE: EPD), for example, now trades above our buy target after sinking to less than $46 per unit in early June. Likewise, units of Linn Energy LLC (NSDQ: LINE), which has hedged the vast majority of its expected oil and gas production over the next several years, plunged to $34 on June 4 and have subsequently recovered to almost $40.

These trends were also manifest in the second-quarter performance of the 21 closed-end funds in our coverage universe. Offerings with midstream-heavy portfolios managed to eke out gains during the quarter, likely because this segment of the MLP universe has the least exposure to commodity prices. Investors also tend to buy these safer names when market sentiment begins to recover.

This explains the recent price action in units of Enterprise Products Partners, Kinder Morgan Energy Partners LP (NYSE: KMP), Magellan Midstream Partners LP (NYSE: MMP) and Sunoco Logistics Partners LP (NYSE: SXL), all of which climbed to levels that exceeded our buy targets in early 2012, tumbled during the growth scare earlier this summer and have resurged in July.

Closed-end funds with substantial allocations to the midstream sector have generally fared better than offerings that branch out into parts of the MLP universe that have greater sensitivity to fluctuations in economic growth and commodity prices. For example, Cushing MLP Total Return (NYSE: SRV) and Cushing Royalty and Income (NYSE: SRF)–the two closed-end funds in our coverage universe that lost ground in the second quarter–allocate sizable portions of their investable assets to upstream MLPs.

Two outliers defy this generalization: Kayne Anderson Energy Development Company (NYSE: KED) and Tortoise Capital Resources (NYSE: TTO), both of which own private securities and real assets in addition to stake in publicly traded partnerships. We prefer to steer clear of these funds because it’s difficult to gauge the value of their underlying holdings.

Top Picks

Our long-standing investment philosophy, which calls for a diversified mix of names with varying levels of exposure to the economy and commodity prices, informs our approach to selecting our favorite MLP-focused closed-end funds.

Although commodity prices could continue to languish in the back half of the year, investors must remember that these conditions are far from permanent.

In fact, the supply-demand balance in the global oil market remains tight, while the eventual construction of additional export capacity could eventually bolster the domestic price of natural gas. NGL consumption will also receive a boost in coming years as Dow Chemical (NYSE: DOW) and other firms finish building world-scale petrochemical plants in the US.

Accordingly, we favor Kayne Anderson Energy Total Return (NYSE: KYE), which boasts a diversified portfolio that also includes a 12 percent allocation to US royalty trusts and a 17 percent allocation to names the marine transportation industry.

In the first half of 2012, the closed-end fund outperformed the Alerian MLP Index by about 6.6 percentage points, though this return lagged the gains posted by offerings that invest primarily in companies that own pipelines. Kayne Anderson Energy Total Return continues to rate a buy under 27.

In general, we prefer building a portfolio of individual MLPs to investing in actively managed closed-end funds, which feature higher fees, and passively managed exchange-traded funds (ETF), which lack the focus on quality that comes with selecting individual stocks.

The key advantage of closed-end funds and exchange-traded funds over individual MLPs is that investors don’t need to deal with multiple K-1 forms during tax season. Instead, the fund will send you a 1099 each year that breaks the distribution down into income and realized capital gains/losses on transactions.

MLP-focused funds also offer the benefit of instant diversification, which helps to cushion the blow if one portfolio holding implodes. There’s also the value of professional management, though that’s difficult to assess with funds that have a short operating history.

ETF Update

In October 2010, Elliott and I interviewed Benjamin Shepherd, editor of ETF Investment Insider and Benjamin Shepherd’s Wall Street.

Since we last checked in with Ben, the universe of MLP-focused ETFs, exchange-traded notes, mutual funds and closed-end funds has swelled to more than 40 offerings. Here’s an edited transcript of our conversation.

Roger Conrad: Glad we were able to catch up with you. Last time we spoke, you highlighted your favorite ETFs for gaining one-stop exposure to energy-focused MLPs. What’s your take on these investment vehicles today?

Benjamin Shepherd: The basic advantages of ETFs haven’t changed since we last spoke. Although you lose the tax-deferral benefits that come with owning units of individual MLPs, many people don’t have the time or inclination to pick their own stocks. For these investors, ETFs offer one-stop exposure to the group.

RC: What about fees?

BS: ETFs have long featured lower expense ratios than similar mutual funds and closed-end funds because they’re not actively managed and usually entail lower trading costs. And now that some of these MLP-focused ETFs have been on the market for a while, their asset bases have swelled, further reducing their expense ratios.

RC: You’ll never convince me that a passively managed ETF is superior to an intelligently constructed portfolio of MLPs. For me and many of our readers, the tax advantages of owning individual MLPs outweigh the headaches involved in dealing with the K-1 form. Still, for the reasons you’ve outline, ETFs still hold a great deal of appeal for some investors. Do you have any favorite MLP-focused ETFs?

BS: Among the handful of MLP-focused ETFs available, I still prefer ALPS Alerian MLP (NYSE: AMLP), which provides exposure to 25 midstream names and has grown to almost $3.4 billion in assets. The fund’s expense ratio of 0.85 percent is a fraction of what some of the closed-end funds in your coverage universe charge. The ETF also avoids wild swings in discounts and premiums to net asset value that are part and parcel of investing in closed-end funds.

I expect Alerian MLP’s asset base to continue to swell, lowering its expense ratio even further and reducing tracking error.

RC: Do you like any other MLP-focused ETFs?

BS: Investors should also consider First Trust North American Energy Infrastructure (NYSE: EMLP), which distinguishes itself from the pack by offering above-average exposure to upstream MLPs.

RC: We’ve talked at length about the advantages of ETFs. Are there any disadvantages of which investors should be aware?

BS: Not beyond what you miss out on by building your own portfolio of individual names. I suppose investors who worry that the federal government might increase the tax rate on dividends might want to avoid ETFs, though that argument applies to most income-paying securities.

RC: I understand that you’re less positive on ETNs these days. What prompted you to change your mind?

BS: Let’s revisit the differences between ETFs and ETNs. Whereas an ETF is a basket of stocks, commodity futures or a hard asset that’s designed to mirror a sector’s performance, ETNs are the junior, unsubordinated debt of the issuer–usually a large financial institution such as JPMorgan Chase (NYSE: JPM).

In other words, ETNs don’t own the securities whose value they’re designed to track. Instead, they’re a bank-issued IOU that promises to track a specific index, minus expenses. This structure entails some risk–if the issuing bank goes bankrupt, investors will have to queue up with other creditors to recover their money.

RC: You warned of that complication last time we spoke. Are there any new developments that have shifted your thinking on ETNs?

BS: Financial institutions have treated ETNs like their personal piggy banks, takidng advantage of this low-cost source of funding in an environment where net interest margins remain under pressure. That’s a powerful incentive for banks to continue rolling out ETNs. But investors should be wary of these investment vehicles. JPMorgan Chase recently opted not to issue any more shares of Alerian MLP Index (NYSE: AMJ), resulting in higher tracking error.

RC: What prompted JPMorgan Chase to make this move?

BS: As ETNs grow in popularity, the hedging costs incurred by the banks backing them increase exponentially, prompting the banks to stop issuing shares. This heightens tracking error, leading the ETN to trade at significant discounts or premiums.

To worsen matters, both the Securities and Exchange Commission and the Commodity Futures Trading Commission are scrutinizing ETNs closely. For these reasons, I prefer ETFs to ETNs.

RC: Thanks for that insight. We’ll adjust our fund ratings accordingly. I have one last question. A lot of subscribers ask about hedging their MLP exposure with an exchange-traded product. What’s the best approach for investors seeking downside protection?

BS: Unfortunately, the one short option, UBS E-Tracs 1x Monthly Short Alerian MLP Infrastructure Total Return Index (NYSE: MLPS), features an inordinately high expense ratio and is an ETN. Needless to say, investors should avoid that exchange-traded product.

You could short ALPs Alerian MLP, the ETF that I mentioned earlier. As of yet, no inverse MLP-focused ETFs have come to market.

RC: Actually, I lied–I have one more question. Do you have any final thoughts you’d like to share before we wrap this up?

BS: The market has grown oversaturated with MLP-focused funds. I’d let at least a year pass before you invest in one of these products to avoid the risk of the issuer pulling the plug.

RC: Thanks, Ben. Subscribers interested in reading more of Ben’s commentary on the wide world of funds should check out the free ETF Investment Insider.