I’ve often read stories in the financial media that exaggerate certain claims, or at best use very imprecise language to describe certain investments. Over the weekend, there was one such post on the Forbes website describing a type of investment known as closed-end funds (or CEFs). You can read the full article by clicking here (or just read the excerpts below).
You don’t have to get too far into the article before the sensationalism kicks in. Here’s a good excerpt:
… since CEFs can get you about $3,000 per month in dividend income on a $500K investment! That could mean retiring a decade or more before folks who rely on low-yielding S&P 500 stocks or ETFs.
Wow! That sounds amazing! It seems like the author is implying that you can safely earn $36,000 per year ($3,000 per month) with only a $500,000 investment. Doing the math ($36k divided by $500k), you end up with an distribution rate of 7.2% per year. Sounds good to me, especially when most financial planners advise clients to withdraw 4% (or less) from their portfolios each year to maintain their savings through retirement.
Not all it’s cracked up to be
If you continue reading the article, the author gives a little bit more detail. The first CEF is called the Liberty All-Star Equity Fund (USA). Here is some of what the author says:
For stock exposure, consider the Liberty All-Star Equity Fund (USA), which pays a whopping 9.6% yield and boasts a portfolio of America’s most successful companies…
Top holdings Alphabet (GOOG), Amazon (AMZN), Facebook (FB) and PayPal (PYPL) tell you right off the bat that you’re getting the biggest and most important US tech giants when you buy USA…
And you get that monster 9.6% dividend, which as we all know is far more than you’d get if you bought these companies individually or through an ETF.
Now we get a 9.6% annual dividend? That’s even better than the 7.2% rate we calculated earlier. And the author claims we can only get this dividend by investing in the CEF, but not by buying the companies directly or through an exchange-traded fund (ETF). That sounds suspicious to me. For reference, the dividend yield on the S&P 500 is about 1.3%. What sort of financial alchemy can get you from a 1.3% to a 9.6% dividend?
Well, none in fact (unless we’re talking about extreme levels of leverage). It turns out that the author here is not being honest about how this and many other CEFs work. It’s true that the Liberty All-Star Equity Fund has a distribution rate around 10%, but those distributions include dividends, capital gains, and some of the investors’ original investment capital. In fact, if you read the most recent quarterly report for this fund, you’ll see that the dividend yield for the portfolio is about 1.1%, which is closer to what you’d expect from investing in stocks right now. The remainder (or the other 8.5%) of the distributions comes from the other two sources: capital gains and a return of capital.
Do your homework
Fidelity actually has a good primer on CEF distributions (you can read it here). The most important point comes at the end:
It is important that investors understand the source of their CEF’s distribution. Many unwitting investors pay extreme premium prices for CEFs that have large distribution rates derived almost solely from destructive return of capital.
If you are planning for retirement and you read an article claiming that XYZ investment company offers amazing dividend yields that are way higher than any comparable investment, then it’s a good idea to pause and think about it. In investing, as in life, if it’s too good to be true, then often someone is not being fully honest.
If you are investing on your own, it’s important to do your homework. Start by reading the reports filed with the SEC. Then get curious about how an investment opportunity works. If you can’t figure it out, move on to something else or ask for help.
If you work with an advisor, make sure to ask them if they understand how the investments in your portfolio work. Ask them to teach you. If they can’t answer your questions or explain things to your satisfaction, consider shopping around for another advisor.
