These Dividends Are Outrageous

With short-term Treasuries close to zero and money market rates not much higher, it's fitting that investors are looking elsewhere to generate some income. Unfortunately, in the scramble to find higher yields, many investors have gotten themselves into some pretty dangerous territory.

Too good to be true?
Closed-end funds have really become popular in the last year, and deservedly so. In 2009, the average closed-end fund returned 51.5% on a share price total return basis. Accordingly, cash-seeking investors have poured their money into the funds, hoping to grab a piece of the pie.

But first, I'd like to explain why you should be seriously cautious about these funds, and second, I'm going to offer five much better opportunities for you to invest in.

To understand these funds, it is important to differentiate them from a regular mutual fund. Closed-end funds are similar to stocks in that they trade not based on their net asset value (NAV), but on the open market, at a premium or discount to the NAV, depending on how the market evaluates it.

According to a recent Wall Street Journal article, 11 funds tracked by Lipper were trading for at least 20% more than their portfolio's NAV. That means that investors willingly paid $1.20 or more for $1.00 worth of assets: This doesn't exactly follow the Buffett principle of paying less for more.

So why the big markup?

Dividends, usually. Closed-end funds have insanely high yields and offer people a chance to generate substantial income while they wait for interest rates to inch their way up from the bottom. Gabelli Utility Trust (GUT), for example, is selling at a whopping 69% premium. By now you can probably guess why an investor would be willing to pay such an incredible premium-- the fund offers an extremely generous 9.4% yield.

Gabelli Utility Trust holds companies like Constellation Energy (NYSE: CEG) and Progress Energy (NYSE: PGN): In my opinion, you'd be better off owning these companies separately. Both sport dividend yields of 2.9% or above and are trading below 13 times forward earnings. Why pay a premium for this fund when you can own the individual parts for less?

Less yield than you think
That 9.4% that you're probably gushing over right now is incredibly deceiving. Closed-end funds have what is called a "managed distribution policy," where they can return to the investor not only a regular dividend, but also long-term capital gains -- and even a portion of your original capital. This is done to provide investors with some semblance of a steady cash flow. Capital gains and original capital shouldn't be included in the yield calculation, but most times, they are. For instance, even though Gabelli's yield looks like 9.4%, the actual "income-only" yield is about 3.7% -- quite a surprise for investors who think they're getting a high traditional yield. (These numbers can be found on the Closed-End Fund Association's website.)

This would be bad enough, but it only gets worse. Closed-end funds can also cut their dividends at any time, without explanation or reason. For example, The Wall Street Journal cited the Dow 30 Enhanced Premium & Income Fund, which cut its dividend in half in 2009 -- with no explanation at all. Shares then proceeded to crumble from a 30% premium to a 3% discount, leaving investors with their share price cut by a third.

Any time a fund randomly chooses to cut its dividend, a run on the fund will typically ensue; not only is your cash flow suddenly depleted, but your shares have been slashed as well. When all is said and done, these funds end up being quite a risky and imprecise investment.

More bang for your buck
Now that I've explained why closed-end funds aren't the best investment vehicle for your hard-earned savings, I'll make good on my promise to offer a much better alternative.

Let's look at an investment that offers the three following attributes:

1. A generous amount of reliable income

2. A track record of continuity and the capacity to raise dividends over time

3. The ability to deliver capital appreciation

Dividend-paying stocks with the characteristics above are far greater investments, because their yields are more transparent, and they can generate not only income, but also growth.

In light of this new information, here are five stocks that fit the criteria we set above:

Data from Capital IQ and DividendInvestor.com.

These are the types of companies that Motley Fool Income Investor seeks out -- stocks that pay generous dividends, have raised those dividends over time, and have illustrated the power of increasing earnings year after year.

It's completely understandable that investors are in search of better yields, but it's important to remember that if a dividend looks too good to be true, it probably is.

If you're interested in learning more about the five stocks that our analysts at Income Investor think you should buy right now, or if you'd like to see all of our past and present recommendations (which are beating the market by an average of six percentage points each), you can be a guest of the service  free for 30 days. Click here for more information.

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This article was originally published on April 29, 2010. It has been updated.

Jordan DiPietro doesn't own any shares mentioned above. The Fool owns shares of China Mobile. The Fool's disclosure policy knows that reinvesting dividends is a major key to financial success.