Eat your peas! Wash your hands! Do your homework!
Sounds familiar, right? None of us got to adulthood without following a set of simple rules. Of course, mom was right... Whether you're a kid or an adult approaching retirement, all of these rules are important.
Especially the homework rule.
Doing your homework, knowing your investments and researching the new ones is a very important and necessary part of being a successful investor.
Worry not, though. If you're a subscriber to my Daily Paycheck premium income newsletter service, I do the homework for you. Even if you sometimes don't feel like it...
Besides researching stocks and funds, my own homework includes a healthy dose of staying on top of all the latest news and studying what others think about the market. Plus, when I can, I also look at what other experienced investors are doing, taking the opportunity to learn from the knowledge and practical experience of others.
But this doesn't just mean we should blindly take positions in companies other experienced investors like, regardless of how rich and famous those investors happen to be.
For instance, when I recommended Phillips 66 (NYSE: PSX) to my subscribers back in February, I considered it a plus that it was also one of Warren Buffett's favorite companies. But that wasn't enough of a reason to recommend it. I needed to do my own homework, too.
Still, unlike the explicit messages of our childhood, many of the investment lessons we learn are rather implied.
Such are the lessons I learned from a recent article about Bill Gross, who is best known for co-founding the investment firm PIMCO, where he managed the world's largest bond fund and earned the moniker of "the bond king."
While warning about the heightened risk in U.S. markets -- a sentiment I just discussed in a previous Daily Paycheck issue -- Bill Gross happened to mention that he likes closed-end funds. And he was very specific, too.
While I don't believe these two closed-end funds were meant to be an exact recommendation -- I also want to make it clear that I'm not recommending either of these two funds by repeating Bill Gross's choice here -- I feel there must be a lesson in all this.
Why these funds? What makes them appealing today as well as a year ago? What do these two funds have in common? Can studying these two funds make us better investors?
The short answer to the last question is yes. And here's what I think the answers to the rest of the questions are. In concentrated form, here's a set of rules we can extract from analyzing the two recommendations (on top of the rather obvious conclusion that Bill Gross likes closed-end funds as an asset class).
Lesson One: Discounts matter. Both of the funds currently sell at a discount to their net asset value. The Duff & Phelps Global Utility Income Fund sells at an 8.8% discount to its net asset value (NAV), while the Nuveen Preferred Income Opportunities Fund sells at a smaller, but still significant, discount of 3.9%. (In the long run, it's much better to buy a fund at a discount than at a premium.)
Lesson Two: Don't be scared of leverage. Both of the funds in question employ leverage to enhance yields. The Duff & Phelps fund's stated leverage is currently 26%, and the Nuveen fund's is 28.4%. These are not the highest possible levels of leverage, but they're not the lowest either. Even though the use of leverage is associated with amplified risks and added costs, it isn't necessarily a bad thing because it can also help closed-end funds generate income. Still, investors should always know whether a fund uses leverage (and how it's using it), and understand the risks associated with it.
Lesson Three: Even the best funds sometimes utilize return of capital. In 2015, the Duff & Phelps fund didn't make any distributions classified as return of capital (ROC), but that wasn't the case for 2013 (40% of distributions classified as ROC), 2014 (29%) or 2016 (32%). On the other hand, since 2013, the Nuveen fund has only been distributing income. Investors should always watch out for ROC because it has the potential to destroy capital and be harmful for fund investors when overused. However, many funds use this tool occasionally; if used prudently, ROC is just another option in an arsenal of tools investment managers can use to enhance yields.
And, finally, a much less general but still very important lesson, a lesson that I've learned from studying the investment mandate of the two funds:
Lesson Four: Utilities, as well as preferred securities, are still OK. These investment sectors are a staple for income investors and, despite the risks from higher interest rates, will remain so for the foreseeable future.
Let Me Help You With Your Homework
I plan to take these four lessons to heart when I look at potential future additions to my Daily Paycheck portfolio. I know my subscribers will, too.
They know the power of the income-generating strategy we use. It's what's grown our model portfolio from an initial value of $200,000 to $357,220 at last count. That's a 78.6% total return, and more than $113,000 of that came from income alone.
This article originally appeared on Street Authority.