At the end of last week's article, which itself was born out of the article that I wrote the week before, I promised to come back to cover closed-end mutual funds (CEFs) and offer up an idea that would help you supplement your individual dividend-paying stocks -- such as the ones I recommend each month in Motley Fool Income Investor.
As a side note, I should say that these three articles were largely written as standalone pieces, so it's not absolutely necessary for you to read the others first, or to read them in any particular order, for that matter.
Indeed, as I mentioned last week, I had no intention of turning this discussion into a three-part series when I published the first article. However, I think we'll be just fine in doing so. After all, if the Star Wars films taught us anything, it's that sequels are OK. It's the prequels that can bite you (need I refer to anything more than Jar Jar Binks? Meesa no think so).
Also, because all the best sequel runs have come in threes, we'll make this our final installment. All right, arcane Star Wars references aside, I think we've got a decent show for you, so fasten your galactic seat belts, and we'll jump into the hyperspace world of dividend-paying CEFs.
Feeling closed-end
First off, I imagine many of you would like to know not only what a CEF is but also why you'd want to own one. To that end, let's cover the basics first. As discussed last week, CEFs are similar to exchange-traded funds (ETFs) in that they are investment companies trading on the major stock exchanges like ordinary stocks.
So once again, the share price is determined by supply and demand, or the normal machinations of the stock market, and is not set to the fund's net asset value (NAV) at the end of each trading day like more common open-end mutual funds. (By the way, NAV is simply a fund's assets minus its liabilities divided by shares outstanding.)
Interestingly, shares of closed-end funds often trade at a material discount to their NAV, which effectively allows you to purchase the assets held by the fund for less than they're worth in the open market -- think of this as being able to buy a dollar's worth of assets for $0.95.
Like regular mutual funds, closed-ends are professionally managed. But because of minimal marketing expenses and lower asset turnover, CEFs tend to have lower operating costs than open-end funds. Investors have to pay a brokerage commission to buy and sell shares -- though that's also becoming more common with open-end funds if you buy through a broker -- but closed-ends have no minimum purchase requirements or percentage-based sales loads, and the funds don't carry 12b-1 fees.
Similar to traditional funds, closed-ends usually distribute their earnings to shareholders via both dividends and capital gains, depending on the focus of the fund. CEFs pay dividends on a regular schedule just like stocks, but the actual amount of the distribution can vary depending upon fund performance. Still, most funds strive to keep them consistent, and you'll typically have several months' warning before a cut.
OK, all that sounds pretty good, but you have to choose your funds just as carefully on this side of the fence, as there are additional risks as well. Many CEFs tend to employ leverage -- which is just a fancy way of saying they borrow money at short-term rates and invest it in long-term securities that should theoretically have a higher yield. If done successfully, this practice will boost earnings and therefore yields. However, if managers aren't careful, the strategy will sour in a rising interest rate environment, and the leverage would then magnify the fund's losses.
As such, leveraged funds are inherently more risky -- at least in terms of volatility -- than non-leveraged funds. However, volatility faced by CEFs is typically still lower than that experienced by individual stocks, and the additional benefits of closed-ends can make them compelling investments. Also, leverage strategies have changed quite a bit since these funds got clobbered by rising interest rates in 1994. Since then, additional leveraging methods have helped these entities better tailor their approach to succeed in varying interest rate environments.
Well, that's the skinny on CEFs, but if you're seriously considering an investment in this universe, I recommend you also check out the wealth of information available from The Closed-End Fund Association and ETFConnect.
The rock
If you're interested in spicing up your yields, consider the BlackRock Dividend AchieversTrust (NYSE:BDV). This fund invests 80% of its assets in the highest-yielding securities included in Mergent's Dividend Achievers Index. (Mergent is a well-respected compiler of investment data that has developed a proprietary screen for dividend-paying stocks called Dividend Achievers. This index has soundly beaten the S&P 500 over the past 10 years, and with a great deal less volatility to boot. In 2003, just 303 companies met the firm's screening criteria, so it's an excellent place to start for seekers of quality dividends.)
The remaining 20% of the fund can be invested in other dividend-paying equities that meet the manager's growth and income criteria.
The BlackRock fund, which launched in December 2003, has a management fee of 0.84%, is trading at a near-5% discount to NAV, and is not currently employing leverage. It now yields a compelling 6.6%.
Caveats: For diversification purposes, you should note that Bank of America (NYSE:BAC), Chevron Texaco (NYSE:CVX), Washington Mutual (NYSE:WM), and Merck (NYSE:MRK) each have a sizable 5% weighting in the portfolio. Also, as was the case with the iShares Dow Jones Select Dividend Index (NYSE:DVY) that I discussed last week, BlackRock Dividend Achievers Trust has a heavy weighting in financial and utility stocks -- currently 43% and 16%, respectively -- which can increase interest-rate-related volatility. Finally, unlike the iShares ETF, the BlackRock fund will also invest in real estate investment trusts (REITs) -- though it currently has a modest 4% weighting in the sector. None of these are bad things, mind you, but you should be aware of the focus.
Enjoy adding some spice to your dividend yields, and Fool on!
Mathew Emmert is thinking prequels may not actually be so bad either. He doesn't own shares of any of the securities mentioned in this article, but he is the editor and lead analyst of Motley Fool Income Investor . The Fool has a disclosure policy .
