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These
ETFs Offer 10%-Plus Yields Powered by Earnings |
Published:
April 7, 2008
Investors
just can't get enough of exchange-traded funds (ETFs). In the
mid-1990s, less than two dozen of these funds were trading on
the American Stock Exchange. Today, more than 600 different ETFs
-- worth over half a trillion dollars in total market value --
trade on all the major U.S. exchanges. In fact, ETFs are the
fastest-growing segment of the fund market. Investors poured
some $146 billion into the 291 new ETFs that debuted last year.
That's an average of nearly 25 new exchange-traded funds per
month (versus only four new closed-end funds per month).
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And the good news for income investors is that ETFs have come a
long way since the first dividend-focused ETF arrived on the
scene in November 2003. Today, there are scores of these funds
for the yield-hungry investor to choose from, with some two
dozen offering yields of up to 10% and higher.
Low-Cost ETFs
Unlike closed-end funds, index-tracking ETFs are not actively
managed. They simply invest in the securities of companies that
are included in a select market index. The fund may invest in
all of the securities in the benchmark index or just a
representative sample of them.
Since ETFs don't require research analysts and other investment
specialists to manage them, their fees are very low. The average
ETF in fund tracker Morningstar's database has an expense ratio
of just 0.43%, while the average closed-end fund has an expense
ratio of 1.27%. As a result, investors get to keep a bigger
share of the fund's returns.
What You See Is What You Get
Another difference between ETFs and closed-end funds: discounts and premiums.
Closed-end funds often trade at a steep discount or premium to
the actual value of the fund's portfolio holdings. Unlike
closed-end funds, ETFs generally trade for what they're worth.
The market price of an ETF isn't driven by supply and demand for
the shares to the same extent. The mechanism that keeps the
market price of an ETF in line with its portfolio value is
complex, but the advantage is clear.
A closed-end fund offers the potential for additional returns if
you buy at a steep discount. If that discount narrows as the
shares rally, then you'll see gains that you wouldn't enjoy in
an ETF. But the reverse is also true. If the discount persists
or widens, you could lose more than you would if the share price
simply traded for what the fund was actually worth. The fact
that ETFs are not quite as exposed to the ups and downs of
investor sentiment is a plus in an already volatile market.
No Fancy Footwork
One word describes the biggest difference between the two types
of funds -- leverage. Many closed-end funds use leverage, that
is, they invest with borrowed money. Leveraged funds borrow
money at short-term rates, typically by issuing preferred shares
or taking out repurchase agreements (repos). They then turn
around and invest the money at higher, long-term rates,
profiting from the difference. They may also use a variety of
complex derivatives -- futures, swaps, and options -- to ratchet
up their exposure to the market with less capital.
Leveraging strategies can give funds more bang for the buck, but
they also add another layer of uncertainty and risk.
When markets sell off and credit is hard to get, leverage can
intensify losses. For example, when the short-term preferred
share market seized up recently, leveraged closed-end funds were
clobbered, and some of the more highly leveraged funds lost as
much as -10% in a few weeks.
What makes ETFs especially well-suited for today's tight credit
markets is that most don't use leverage. When you buy an ETF,
you're essentially betting on the direction of a sector or an
index. You're trying to match the returns of a benchmark index,
not beat it through the use of leverage.
Earnings-Driven Dividends
Like closed-end funds, ETFs must distribute at least 98% of
their earnings and capital gains each year as dividends to
shareholders to avoid paying federal taxes. The big difference
is that ETF dividends are largely driven by what the fund
actually earns. In contrast, closed-end funds typically draw
upon a variety of sources to maintain their dividend level, even
if earnings come up short.
Since most ETFs are designed to track an index, their portfolios
have fewer trades and lower turnover than a more actively
managed closed-end fund. As a result, ETFs tend to have fewer
capital gains payouts, which can trigger extreme swings in the
share price (as well as a hefty tax bill) that can drag down
returns. Further, ETFs don't seek to actively maintain
distribution levels with "return of capital" payments that
simply pay back your original investment.
Most ETF dividends qualify for the lower dividend tax rate
of up to 15%, making these funds suitable for a taxable
brokerage account. Income from bond and REIT ETFs may be taxed
at your ordinary income tax rate of up to 35%, so these funds
should be held in a tax-advantaged account if possible.
Today's Top Picks
To identify today's picks, we zoomed in on funds that have
outperformed the S&P 500 over the past six months. While the broad-based index lost
more than -10% in that time frame, our top two picks charted a steady
course in extremely turbulent waters. And they are
well-positioned to continue to outperform the market in the
months ahead. Here's why...
Important Note: In the
remainder of this article,
High-Yield Investing editor Carla Pasternak provides
a listing of 24 ETFs with yields as high as
14.6%. In addition, she provides in-depth profiles of her two
favorites, both of which have held steady in the face of a falling
market. However, in order to view the remainder of this
article, you'll need to subscribe to our premium income-investing
newsletter --
High-Yield Investing. After you subscribe, you'll
receive immediate access to this full article, as well as our
monthly
High-Yield Investing newsletter and a host of
additional premium content. Please visit one of the following
links to continue.
Good investing!
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
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Income Security
of the Month
Our "Income Security of the Month" for May 2008 invests in
a fast-growing overseas market that doesn't get much exposure in the
mainstream financial press. And although it typically makes enormous
annual dividend payments -- it has paid an average dividend of 24.5%
per year over the past five years -- this fund is perhaps most
appealing for its total return potential. Specifically, the fund has
delivered total returns of +297.3% since 2003, and
it ranks in the top 10% of its category over the past decade.
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Top
10 Stocks for 2008!
Since we began publishing this report back in 2003, the picks we've
featured have consistently beaten the broader market -- delivering average
gains of +21.3% per year and outperforming the S&P by a nearly
2-to-1 margin. Act now to reserve your copy of our newest report -- Top
Ten Stocks for 2008. |
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