3 Isn't Always Better Than 1

There are lots of ways investors can try to generate more income for their portfolios. In practice, though, it's rare to see specific mutual funds and exchange-traded funds (ETFs) use more than one income-producing strategy at a time. One closed-end fund bucks this trend by offering a trifecta of methods intended to boost the fund's income as much as possible, yet the results aren't what you'd hope to see.

Pay me three times
The NFJ Dividend Interest & Premium Strategy Fund (NYSE: NFJ  ) uses three distinct strategies to come up with what it thinks will be the best investments for its shareholders. The first approach is the simplest: The fund looks at large-cap stocks to find companies that combine high dividend yields, low price-to-earnings multiples, and strong business fundamentals. The fund's top holdings are currently ConocoPhillips (NYSE: COP  ) and Windstream (NYSE: WIN  ) , which demonstrate how varied a set of stocks the process comes up with.

ConocoPhillips has a healthy 4.4% yield and has the potential to grow substantially after 2009's profit flop if oil prices stay close to current levels. Windstream, on the other hand, has limited growth potential and has seen a string of disappointing earnings recently, but its 9.5% dividend yield makes up for some of those shortcomings.

In addition to individual stocks, the fund also holds convertible securities, which combine a current income stream with the chance to reap additional profits if a company's shares rise above a certain price. For instance, the fund owns convertible notes of JA Solar (Nasdaq: JASO  ) , which pays an annual rate of 4.5% and gives the fund the right to convert to shares if the price rises above $30.47. Similarly, the fund owns several convertibles issued by JPMorgan Chase (NYSE: JPM  ) , paying rates as high as 10%.

Given that both of these issuers pay little or no dividend on their common shares, preferreds are the best way to get current income. Moreover, convertibles are less sensitive to the underlying common stock price and often are less volatile during choppy markets. So as long as JA Solar and JPMorgan can pay off the securities at maturity, the fund won't suffer the same losses it would have if it had bought common shares of these two companies.

Lastly, the fund writes call options on various indexes, including broad-market measures like the S&P 500 as well as more specialized ones such as the Philadelphia Bank Index. The options the fund writes tend to have relatively short terms, often expiring within just a few months.

Does it work?
With this combination of strategies, it's interesting to look at how the fund has performed. At first glance, its five-year average annualized gain of 1.7% on a net asset value basis, while not all that great in absolute terms, is considerably better than the S&P's small loss.

The problem, though, is that because NFJ is a closed-end fund, shareholders shouldn't judge their performance based on net asset value. Instead, investors have to buy and sell shares on the open market, and as a result, performance measures change significantly. The five-year return figures, for instance, turn to an average annual loss of 2.4%, falling behind 75% of its peers.

More recently, though, the distinction between market value and net asset value has worked in shareholders' favor. On a market price basis, the fund has jumped more than 26% in the past year, versus a net asset value gain of 17.6%. And at a current discount to net asset value of more than 17%, NFJ's shares are still bargain-priced and could benefit substantially if discounts continue to narrow further.

Mixed results
Overall, although the concept behind the fund is reasonable and interesting, NFJ hasn't lived up to its full potential. You might have expected the fund to be substantially less volatile than the market, with the call-writing strategy dampening the potential upside but the convertible strategy reducing the downside risk. Yet looking at the fund's annual returns, you can see that it lost almost as much as the S&P 500 during 2008, while falling well short of the index's bounce-back returns last year.

Moreover, the fund's current yield of 3.8%, while above the overall market's yield, isn't all that high in comparison to many solid dividend-paying stocks. Going to the trouble of combining three strategies doesn't seem to generate that much extra income.

The most attractive thing about NFJ right now is its discount to net asset value. Those willing to bet on that discount disappearing could see a big capital gain. For longer-term income investors, though, sticking with tried and true dividend stocks is probably the smarter move.

You can learn a lot from the stock market's smartest experts. Fool Anand Chokkavelu reveals how Peter Lynch destroyed the market.

Fool contributor Dan Caplinger is a sucker for closed-ends at a discount, but he doesn't own shares of the securities mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Having the Fool's disclosure policy is like hitting a hole in one.


Read/Post Comments (0) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1194316, ~/Articles/ArticleHandler.aspx, 8/30/2014 12:20:08 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement