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In today's income-starved world, everyone's looking for investments that will pay them back with solid streams of dividends. But although certain investments promise yields that look positively spectacular, you'll find an uncomfortable surprise when you dig a little deeper.

High yields and managed payouts
With dividends on the rise and dividend stocks never having been more popular, finding attractive yielding investments is easier than ever. But if you're looking to earn some real income -- say, 10% or more on your money -- the pickings are a lot thinner. Finding a 10% yield limits your choices greatly. If you need a 10% yield, you can expect to find things like this:

  • Mortgage REITs like American Capital Agency (Nasdaq: AGNC  ) are highly leveraged real estate investment trusts that borrow short-term and buy long-term assets. When interest rates are favorable, as they have been for a while, American Capital Agency and its peers cash in with huge dividends. When rates are less favorable, though, dividends can shrink quickly.
  • Master limited partnerships like Cheniere Energy Partners (AMEX: CQP  ) are tied to the production and sale of natural resources such as oil, natural gas, or mining products. When prices are high and production strong, yields can go sky-high. If prices fall or an MLP runs into production problems, then yields can fall in a hurry.

But there's one other area of the market where you'll find high yields: closed-end funds. Take a look at these big yielders.

Fund Name

Trailing Distribution Yield

Premium/Discount to Net Asset Value

Cornerstone Progressive Return (AMEX: CFP  ) 17.5% 22.7
Mexico Fund (NYSE: MXF  ) 11.9% (10.6%)
Aberdeen Chile Fund (AMEX: CH  ) 9.9% 5.7%
Gabelli Equity Trust (NYSE: GAB  ) 9.6% 0.0%
Zweig Fund (NYSE: ZF  ) 11.3% (7.2%)

Source: CEF Connect.

It's true that some of these funds have their money in promising investments. As emerging markets, Chile and Mexico haven't exactly gotten the attention that Brazil and China have, but they have some strong prospects all the same.

But as it turns out, these funds don't rely on the investments they make to generate those huge yields. By using a "managed payout" strategy, they simply choose to pay money back to investors -- and if the investments they make aren't able to cover the tab, then the funds will be happy simply to give you your own invested capital back and treat it as income for purposes of measuring yield.

Getting paid with your own money
Before you dismiss the concept of managed payouts as outrageous, keep in mind that sometimes, having a predictable stream of income is actually desirable. Because closed-end funds trade only on exchanges rather than through mutual fund companies, shareholders are never guaranteed that they'll get back the true value of their shares. So in some cases, the only way an investor can feel confident about getting money out of his or her fund without taking a huge haircut is by getting managed-payout dividends.

What you shouldn't do, though, is think that you're automatically getting a great deal with these huge yields. Yet with some of these funds, that's exactly what investors are doing. Although the Mexico Fund and Zweig Fund trade at discounts to their net asset values -- a typical state of affairs for most closed-ends -- the Cornerstone and Aberdeen funds both sport fairly substantial premiums. You can bank on the fact that high yields are driving interest in these funds -- and that at some point ,when investors realize that their returns won't necessarily keep up with those managed payouts, the premiums could disappear along with those attractive yields.

Take care of your money
Funds that have managed-payout strategies aren't necessarily a terrible deal for investors. But if you buy into them simply because their yields are huge, you could easily end up disappointed. Only by fully understanding where those big payouts are coming from and the risks involved in trying to capture them going forward will you be able to protect yourself if something goes wrong.

If you like the ease of trading with closed-end funds, you should also consider exchange-traded funds. For some ideas on ETFs with some spice to them, check out the Motley Fool's special free report on ETFs. You'll find three great funds to help boost your core portfolio's returns.

Fool contributor Dan Caplinger never pays a premium for a fund. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never tricks you.

Read/Post Comments (1) | Recommend This Article (13)

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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.

  • Report this Comment On June 30, 2011, at 3:39 PM, constantnormal wrote:

    Gosh, all of what the author has said about closed-end funds, and especially those with managed dividend streams is true, but when I went and actually compared the funds listed to the S&P 500 index, I got quite a different picture.

    Basically, the S&P 500 has gone nowhere over the past 5 years, and while all of the funds listed (except one) had share prices that had declined over that time, most had a pretty good total return when you factored in those juicy dividend streams.

    And the one that showed a 5-year absolute gain over the S&P was the Chile Fund (CH), with a share price gain of over 50% over the past 5 years -- and that's WITHOUT considering their juicy dividend stream.

    The lesson here? Learn from the concepts presented in these articles, but verify the claims yourself. You might learn even more. It's easy to compare, just go to any of a bazillion free charting sites and plug in the tickers. Run the comparisons for several intervals, not just one. At the 2-yr point, CH was showing shr price just a tad below the S&P index -- but that's without considering the dividend stream -- and MXF was rockin'. One would expect all of these funds to be a lot more volatile than the S&P 500, as none of them are as diversified as the S&P.

    The only ones to bear out his cautions were the CFP and ZF funds, which underperformed the S&P on a total return basis in any interval one cared to examine.

    But don't take my word for any of this -- check it out for yourself.

    Full disclosure -- I own shares in CH.

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