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Investing Specialists

The Error-Proof Portfolio: Don’t Give Thanks for Faux Income

Beware of investments that give with one hand and take away with the other.

Thanksgiving is a time of fun, food, and football-watching with friends and family, but it's also an ideal occasion to take stock of all of that's right in our lives. And the truth is, most investors have plenty to be grateful for this holiday season. With the exception of a few scary moments like the flash crash and the spring sell-off, both stocks and bonds have generated robust returns for the year to date.

But times have been tough for those who look to their portfolios for current income from their investments. Yields on one-year certificates of deposit are barely above 1%, while most intermediate-term bond funds have SEC yields significantly less than 3%. To generate a livable income stream at this juncture, you'd need to have an awful lot of wealth or venture into some risky investments.

The trouble is, those in the latter camp may not even know they're taking a lot of risk to generate their current level of income and eroding their principal values in the process. Or worse yet, they may not realize their fund is dishing out income that's really just a return of their own cash. Such funds are the equivalent of moving money from one pocket to another.

So before you clink your glass to an investment that is delivering a yield of 6%, 7%, or even higher, take a moment to consider the sacrifices it might be making to do so.

Moving Money From One Pocket to the Other
For some funds, what may look like an impressively high yield is in fact a return of the investor's own principal, either directly indirectly. Of course, return of capital isn't always nefarious, as this article discusses. And some of the relatively new retirement-income funds, such as Fidelity's, make it explicit that part of the return shareholders receive is their own capital.

But there are a number of bad return-of-capital strategies in the closed-end fund realm. Cornerstone Progressive Return , a closed-end fund, serves as a great illustration. On the surface, the fund appears to be just what yield-seekers are looking for in this low-yield environment, serving up double-digit distributions in each of the past few years. (That also helps explain the fact that it and its siblings trade at perennially large premiums to their net asset values.) A peek at its Distribution page, however, shows that the fund hasn't produced much real income at all. Instead, most of the distribution that shareholders have received is simply a return of shareholders' own capital. So-called "dividend-capture" funds don't return capital directly. But as Mike Taggart discusses in this article and video, their strategies amount to a return of capital laundered through a dividend-focused strategy.

Capital Eroders
Even if funds aren't simply handing back investors' own capital, their managers may be taking outsized risks to deliver a relatively high yield. As a result, shareholders may see their net asset values diminish even as a fund's yield remains attractive. Bank-loan fund  Invesco Van Kampen Senior Loan (XPRTX), a conventional mutual fund, provides a stark case in point. Due to a combustible combination of leverage and bank-loan holdings from market sectors that were hit hard during the recession, the fund shed nearly half of its value in 2008. And even though it mounted a stunning comeback in 2009 (and underwent a management change), the fund's net asset value is still about 30% below what it was a decade ago.

How to Spot Them
So how can you spot funds whose yields aren't all they're cracked up to be? Checking a fund's total return history rather than investing solely on yield is a good starting point. You can also look at a fund's historical net asset value, available on the chart page of Morningstar.com snapshots for mutual funds, closed-end funds, and exchange-traded funds. Users can adjust the time frame to see the extent to which a fund's NAV has declined--if at all--over a given period. A slight decline in a fund's NAV shouldn't set off alarm bells, but steep declines in NAV are a red flag.

Looking at the annual Income Return % and Capital Return % lines on PDF pages for individual mutual funds, such as this one for  Northeast Investors (NTHEX), can also provide a sense of how a fund balances yield with total return. Finally, prospective closed-end investors concerned about whether a fund's distribution consists in part of a return of capital can view its Distribution history.

See More Articles by Christine Benz

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