The Hidden Secret Behind These High Yielding Passive Income Favorites

Investors are looking for passive income wherever they can find it. It’s much easier to collect a quarterly check from a dividend-paying stock than to find a second job or take on a gig job. And for many investors, the higher the return on a passive income investment, the more they value it.

Recently, closed-end funds have attracted a lot of interest due to their high distribution yields. However, there are several things every investor considering these passive income favorites should know about closed-end funds before buying stocks. Here are those hidden secrets.

1. High returns come from funds that return your own money

Closed-end funds are allowed to make distributions from three sources: dividends and interest they receive on the investments they hold, capital gains on the investments they sell, and return of capital. investors. Unfortunately, it’s often this third category that pushes a closed-end fund’s return to attractive levels – and all of this means you’re paying management fees to get your own money back.

Take Aberdeen Global Dynamic Dividend Fund (AGD 0.95%) for example. He owns some of the most well-known stocks in the market. But those stocks yield nowhere near the fund’s 8.3% payout yield.

So how does the fund pay out so much passive income? It returns shareholders’ capital to supplement the dividend income it receives. From November 2021 to April 2022, more than half of the $0.39 per share of Aberdeen Global Dynamic Dividend’s total distributions represented a return of capital. This makes the return artificially high and can mislead shareholders into not realizing that they are just getting back the money they previously invested.

2. It may be cheaper to buy the underlying stocks yourself

Many closed-end funds invest in common stocks that you could buy yourself. Yet, because closed-end funds trade on exchanges and do not include provisions for investors to buy or sell shares directly from the fund companies, the stock prices of the funds can be much higher or lower than the underlying value of the investments they hold.

For instance, Gabelli Equity (ATMs -0.80%) invests in perfectly ordinary stocks, with blue-chip securities, including Deere, MasterCardand Berkshire Hathaway. However, the closed-end fund uses leverage to generate more income to support a nearly 10% distribution yield. For this high return, investors were willing to pay 20% more than the actual value of the investments held by Gabelli Equity.

Closed-end funds can trade at premiums for a long time, but those premiums usually disappear. When this happens, investors in the fund may lose money even though the value of the investments held by the fund increases. It’s a slap in the face for those looking for passive income.

3. Many closed-end funds have high fees

Investors in index funds and exchange-traded funds are used to paying 0.1% per year in annual expenses or less to own their shares. However, closed-end funds typically have much, much higher expense ratios that sap the value of your investment over time.

For example, the Gabelli Equity fund charges an annual expense ratio of 1.37%. Aberdeen Global Dynamic Dividend weighs 1.18% per year. And you can find closed-end funds that charge 2% or more per year. Regardless of the distribution yield, it is difficult to generate enough outperformance to pay for these high fees.

Passive income investors beware

Closed-end funds have attractive features, but there are complexities behind them that many investors don’t understand. Don’t invest in these passive income generators until you know exactly how they work and whether they truly deliver on their promise to shareholders.

Dan Caplinger has positions in Berkshire Hathaway (B shares). The Motley Fool holds positions and recommends Berkshire Hathaway (B shares) and Mastercard. The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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