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Published: December 29, 2009
The key to boosting income lies in a
security most investors might not be familiar with.
Nevertheless, more than 1,250 of these securities trade on U.S.
exchanges. They invest in every almost every possible sector and
niche of the market (from stocks and bonds to
REITs,
MLPs,
municipal bonds, preferred stocks, and more). But what they're
best known for is income.
These securities are called
closed-end funds.
Closed-end funds are publicly traded investment companies that
raise capital through an
initial public offering and then use the proceeds to invest
in securities.
Similar to common stocks, closed-end funds usually trade on one
of the major U.S. exchanges. However, unlike regular stocks,
they represent an interest in a portfolio managed by investment
advisors. These managers typically concentrate on a specific
industry, country or sector.
Unlike traditional open-ended mutual funds, closed-end funds
don't have cash going in and out of the fund -- only a set
number of shares trade. If you want to buy in, you purchase your
shares from another investor, just like a stock.
The structure lends itself to paying out high income because
they don't have to keep money available for redemptions and can
invest all its assets.
It shouldn't be a surprise that closed-end funds that pay income
are easy to come by. A quick screen shows 487 CEFs currently
yielding more than 7% -- 187 yield 10% or higher.
Even better, most closed-end funds pay distributions on a
monthly basis -- 897 of the 1,275 to be exact.
Adding one of these high-yielding gems to your portfolio should
give your monthly income a quick boost. However, the last thing
any investor should do is buy into a fund simply because it pays
an enticing yield.
Just like any other investment, you need to do your homework.
But since funds are different than a normal stock, there are
three unique metrics you should keep an eye on:
Performance During the Downturn
How has the fund performed in good markets and bad?
How has the fund performed relative to its sector?
Does the fund perform well in the long term and/or the short
term?
If you're most worried about safety, a good place to start
your search is with funds that were able to hold up in the last
downturn. These may not offer sky-high gains in a rising market,
but they've proven their mettle in one of the worst downturns in
recent memory.
Discounts and Premiums
Sometimes closed-end funds trade out of line with their net
asset value, meaning the share price may be higher or lower than
the per-share value of the assets held by the fund.
Some funds may trade out of line with their net asset value for
years. Therefore, it's important to look at the discount or
premium in relation to its historical average. The key is to
find funds trading for less than their average historical
discount or premium.
Avoid Return of Capital Distributions
Before buying into any fund, you'll want to know where the
dividend payments are coming from. You can usually find this by
look at the last year's tax breakdown on the fund's website.
Many funds have "managed distribution policies." This is a fancy
way of saying they plan to make the same payment each month, no
matter how much income the fund earns from investments.
Usually the fund sets payments at a sustainable level. But in
some cases, a fund may earn less income than it pays out --
forcing it to dip into its assets to maintain the payment.
These distributions are classified as return of capital. Such
payments are simply a return of your principal and erode the
value of the fund. In short, it's usually best to avoid funds
making return of capital payments.
-- Tom Hutchinson
Staff Writer
StreetAuthority
P.S. -- My colleague Nathan Slaughter has been following
closed-end funds for years. He's convinced that CEFs and their
cousins,
exchange-traded funds are becoming "the most powerful
investment vehicles on the planet". Nathan is offering a free
webcast to StreetAuthority readers to share his insights on
these simple, but extraordinary securities.
Click here to watch it. |
