When the subject of passive income comes up, many investors will immediately think of dividend stocks. And rightly so. The best dividend stocks can generate reliable annual income with little effort on your part.
Allow me to offer a different angle, though. Forget buying individual dividend stocks. Here's an even better way to make passive income.
A lesser-known alternative
You've no doubt at least somewhat familiar with mutual funds. You're probably well-acquainted with exchange-traded funds (ETFs). But there's a sort of hybrid between the two types of funds that you might not have heard much about.
Closed-end funds (CEFs) are a special type of mutual fund. The term "closed-end" is used because a fixed number of shares is issued upfront to raise capital. Unlike open-ended mutual funds, no new shares will be issued. CEFs are also like ETFs in a key way: They can be bought and sold on major stock exchanges.
Like most mutual funds, CEFs are actively managed. The portfolio managers for these funds typically focus on investments that generate exceptionally high income. More than 200 CEFs offer distribution yields of at least 5%. Over half of them have distribution yields of 7% or higher.
One key advantage of CEFs compared to buying individual dividend stocks is that they're more diversified. The funds often own a large number of holdings. Also, the managers of CEFs have greater access to high-yield investments that many small investors don't, including corporate bonds and preferred stock.
Some good examples
CEFs come in several flavors. You can mix and match to suit your individual preferences.
Some of the funds focus primarily on bonds. For example, the AllianceBernstein Global High Income Fund (AWF -0.29%) mainly invests in corporate bonds with some government bonds thrown in as well. The CEF's distribution yield currently tops 8%. It also trades below the net asset value (NAV) -- the sum of the fund's total assets minus its total liabilities.
For investors who are interested in preferred stock, the Nuveen Preferred & Income Securities Fund (JPS) stands out as a potential candidate. This CEF invests at least 80% of its money in preferred stock and other income-generating assets. The fund's distribution yield is nearly 7.8%. It trades at a discount to its NAV of more than 7%.
Quite a few CEFs own a broad basket of dividend stocks. The Aberdeen Global Dynamics Dividend Fund (AGD 0.80%) is a good example. This CEF invests in dividend stocks across a wide range of industries. It boosts the income generated by using leverage (borrowing). The fund's distribution currently yields over 8.3%. It also trades at a discount of more than 11% to its NAV.
Maybe not totally forget dividend stocks
There are plenty of other CEFs to consider beyond the aforementioned examples that offer juicy yields. These funds can be a great way to make significant passive income.
The biggest disadvantage to CEFs, though, is that you must pay annual fees. Many of the top CEFs have expense ratios of around 1%. But the additional passive income they can generate often makes the fees worth the added cost.
Because of these fees, though, you might not want to totally forget about individual dividend stocks. Some dividend stocks have yields just as attractive as those of the top CEFs without added expenses. There are several great dividend stocks that investors can safely buy and hold.
However, not every investor has the time to research and buy enough of these stocks to be well-diversified. If you're in that group, CEFs could provide a better option to make passive income.