Where's the Yield?

Low yields on Treasuries and high-quality bonds are pushing income investors to take on more risk in search of yield. But where can they find it? And what are the risks?

The funds
A number of high-yielding exchange-traded funds are cranking out juicy yields and a little digging into the fund assets will shed some light on the risks involved. The table below lists the five highest-yielding ETFs with more than $300 million in assets according to ETFdb:

Fund

Index Tracked

Current Yield

Expense Ratio

iShares FTSE NAREIT Mortgage Plus Capped Index (NYSE: REM  ) FTSE NAREIT All Mortgage Capped Index 8.71% 0.48%
PowerShares CEF Income (NYSE: PCEF  ) S-Network Composite Closed-End Fund Index 8.05% 0.50%*
SPDR S&P International Dividend (NYSE: DWX  ) S&P International Dividend Opportunities 6.74% 0.45%
PowerShares Financial Preferred (NYSE: PGF  ) Wells Fargo Hybrid and Preferred Securities Financial Index 6.58% 0.66%
PowerShares Preferred (NYSE: PGX  ) B of A Merrill Lynch Core Plus Fixed Rate Preferred Securities Index 6.43% 0.50%

Source: www.ETFdb.com and fund managers' websites. *Excludes fund fees of closed-end funds in which this ETF invests.

FTSE NAREIT
The FTSE NAREIT fund invests in mortgage REITs. mREITs generate their big yields with leverage; borrowing at the short end of the curve to buy mortgage-backed securities. Over the past several years, this group has consistently cranked out awesome payouts for investors. However, narrowing interest rate spreads and prepayments are growing risks to those juicy payouts.

In addition, the FTSE NAREIT fund is not only concentrated in one asset class, its top two holdings -- Annaly Capital and American Capital Agency -- account for nearly 40% of fund assets. Add in the next two holdings, and only four positions make up nearly half the fund. Investors interested in this fund should ask themselves: Why not just buy Annaly and/or American Capital and save the fees?

CEF Income
No one can accuse CEF Income of a concentrated portfolio. CEF stands for closed-end fund, and this fund of funds holds 124 of them, most of which specialize in bonds or option income. The largest holding is the Eaton Vance Tax-Managed Global Diversified Equity Income Fund, which holds a global stock portfolio and enhances income by writing call options against the holdings. Executed well, writing covered calls gooses a portfolio's income; executed poorly, it caps the gains while capturing most of the downside risk. In addition to option strategies and interest rate risk on the bond holdings, many of the funds hold international securities or use leverage adding currency risk and volatility to the mix.

Fees are another factor. The ETF runs a reasonable 0.50% expense ratio, but expenses from the underlying closed-end funds tack on another 1.06% to expenses.

S&P International Dividend
The S&P International Dividend fund is exactly what it says. The index "is designed to measure the performance of the 100 highest dividend-yielding common stocks and ADRs listed in primary exchanges of countries included in the S&P/Citigroup Broad Market Index." The three largest holdings are Australia's Westpac, U.K.-based Aviva, and Italian roadway and infrastructure company Atlantia. But as the fund's risk profile says, "Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets."

Financial Preferred and Preferred
When the same fund provider offers up a Financial Preferred and a Preferred fund, my initial assumption was that the Preferred fund would be diversified across industries. That might be logical, but it isn't correct. The Preferred fund holds more than 90% of its assets in financials, compared to all financials in Financial Preferred. As the names imply, these funds hold preferred stocks. Like bonds, preferred stock has some interest rate risk and a spot check of several of the larger holdings showed many of the preferreds are trading at a premium and callable at par at some point in the future. That means there's a near certain loss of principal that will offset some of the nice yield.

Summary
Based on current ETF yields, asset classes with some of the highest current yields are:

  • Mortgage REITs.
  • Closed-end funds.
  • International stocks.
  • Preferred stocks.

Of these five ETFs, I think the S&P International Dividend fund offers the best risk-reward ratio. While international investing can be risky, some global diversity in a portfolio is unquestionably a good thing. I'll join the reach for some worldwide high-yield with an outperform CAPScall on the fund.

Securities in these areas offer investors high yields with higher risks tagging along hand-in-hand. Investors considering these funds or the types of assets the funds hold need to look beyond the yield and be sure they're comfortable with the risks and expenses before leaping into the high-yield pond.

Fool contributor Russ Krull has no position in any fund or company mentioned. You can follow his stock picks here. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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