No question about it, dividends can be excellent. They provide income, and when reinvested, allow your money to compound quickly. But not all dividends are created equal.
Some are suspiciously high -- too high to be real.
Beware "fake" dividends
Suppose you put $1 into an investment that earned 4% per year. Now, suppose you paid yourself 8% of your investment each year in dividends.
You know that this wouldn't be sustainable. You can't pay yourself an 8% dividend yield off an investment that only earns 4%. But many stocks and closed-end funds are doing just that -- paying out more than they actually earn.
It's that time of the year when many companies reveal that their big dividends paid throughout the year really just have been return of capital -- money returned from the investors' principal, not from income.
Fighting returns of capital
Returns of capital affect many closed-end funds, big and small. One of the largest and highest-yielding, EV Limited Duration Income (NYSEMKT:EVV), pays a yield of about 8.5%. Last year, some 7% of its payouts were returns of capital -- the investors' money coming back.
It's hardly the worst offender. Eaton Vance recently pointed out that 30% or more of dividends paid by many of its closed-end funds may ultimately be recorded as a return of capital. In fact, one fund's dividends were 96% returns of capital. Eek!
The upside is that a return of capital is not income, so it isn't taxed at the time of distribution. The downside, however, is that each return of capital reduces the amount of money you have at work in the markets. And, over time, it's only natural that your dividend stream will decline with your principal.
Staying ahead of the game
In truth, it's not easy to avoid returns of capital altogether. The fact is that most investors don't know whether their dividends were from income or their initial investment until the year is almost over. And you don't know for certain until tax forms arrive the next year.
But there are some ways to ballpark the source of your dividends:
- Look at historical tax information available on the company's website. This should show what percentage of distributions came from capital gains, income, or returns of capital. The worst offenders are often repeat offenders.
- Compare performance with distributions. Multiply the net asset value yield times net asset value and compare that figure to the dividend rate. For example, if a fund has an NAV of $10, and a NAV yield of 10%, then it shouldn't pay much more than $1 in dividends.
All in all, being cognizant of the fact that your dividends actually may be your own money being paid back to you is the best way to avoid this high-yield trap. Not all dividends are created equal.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.