Many months ago I did a piece trashing conventional open-end mutual funds. I have no regrets. I promised that if even one person asked, I’d explain about other investments that may be better alternatives for most people who want to make money (rather than pay it to people in return for losing them money). It took a very long time, but someone finally asked.
Disclaimer: I am not an investment professional, and none of this is to be taken as a recommendation to transact any particular security. Examples given are not recommendations, merely samples so that the reader may get a look at one as a starting point for broad-based research. I assume no responsibility for anyone’s independent investment choices, and urge everyone to do careful research before choosing to put money at risk. All investment entails risk, and it is wise to consult a fee-only professional advisor for actual investment guidance.
ETFs (exchange-traded funds) and CEFs (closed-end funds)
These are also mutual funds, and are more similar to one another than different. Both are pooled investments that do not regularly issue new shares, so once they sell off the full initial offering, they trade on the open market like stocks. Both have tickers that look like normal Nasdaq tickers, typically three letters, sometimes two or four, whereas conventional mutual funds have five-letter tickers ending in X. A given fund’s description should say whether it is a CEF or ETF on your brokerage’s website, and the prospectus certainly will.
You will, of course, read the prospectus? With nearly all of them in downloadable .pdfs, it’s pretty rash not to do so. I’d read the most recent annual report, too. You especially want to take a look at what it holds, because what it holds would be what you would own.
Here’s the salient difference: ETFs are designed never to trade too far from NAV (net asset value…the total value of assets owned by the fund, minus any liabilities, divided by number of shares; we might call it the ‘basic share value’). This is because big hitters can swap in their ETF shares for what’s called a ‘basket’ of the underlying shares, and the market has different rules for the big boys and girls. CEFs do not allow this swapping. It assures that ETFs will always trade close to NAV, which itself fluctuates based on the underlying securities’ value. By and large, most ETFs are invested in stocks, and many are indexed–they seek only to mimic a given index, owning that index’s components in exact proportion to it.
Since CEFs can trade at steep discounts or premiums to NAV (most are fixed income dividend payers), opportunities periodically occur to purchase their shares at steep discounts to NAV. This is because market fear or euphoria, as I see it, is priced in twice. Suppose the NAV is $10, and it pays $0.70 annually based on NAV. That’s a fairly typical yield relative to NAV of 7%. But you don’t give a damn about the NAV, because the yield you will receive is based on what you pay, not the NAV. So, suppose you waited until you could get it for $8 (or as you would tend to evaluate it, a 20% discount to NAV, assuming the NAV happened to remain at $10 just for the sake of the illustration), and you buy. Your yield will be 8.75%. The yield relative to NAV means little, since you didn’t pay NAV. The annual payout, divided by what you paid, is your yield in an income investment.
1.75% is a significant difference, and since most pay monthly, you get paid often. I believe that the divergence between NAV and market price is the impact of fear (or euphoria). If people are dogging fixed income, the NAV will drop because many people are selling the bonds. However, the market price will also drop because people are selling the fund. I believe that this can present buying opportunities for those with patience and discipline. It is also easy to take the market pulse on high-yield fixed income just by seeing whether a number of bond CEFs are trading at discounts or premiums to NAV. I have zero interest in shopping unless I get a ridiculous discount. The notion of paying NAV, or buying at a premium, isn’t for me. I want to buy when they’re jumping out the windows. Before they jump, if the price is cheap enough, they can sell me their shares if they like. Or not. Someone else will be along soon enough.
What’s the catch with CEFs? Most are invested in higher-risk high-yield bonds. There might be Kenyan government bonds, bonds from some outfit in Pakistan, whatever; depends on what the fund’s prospectus says they hold or can hold. Most are very well diversified, much more so than many stock funds, with issues spread around many sectors. It is possible that this bond or that bond might fail to perform, but it is unlikely that the whole portfolio will go bust. And over the years, you collect a steady yield. The better you bought, the better your yield, and if you bought cheap enough, you probably have an unrealized capital gain at any given time. Now, that yield can decline if the overall interest/dividends paid to the fund happen to decline. There’s no guarantee. However, in practice, it probably will not go too far in any direction. And of course, one must always consider one’s comfort zone. Not all CEFs buy more speculative bonds. If you’re willing to take less return, you can find funds that go with higher-grade stuff, which pays less.
Most of my stock-related investing is in index ETFs, and all my bond-related investing is in CEFs. It is boring and successful, just the way I like my investing. I don’t do this to be excited; I do it to make money, and if I get my money, I am satisfied.
PTPs (publicly traded partnerships)
These are weird creatures. One often hears them called LPs (limited partnerships). They look like stocks until it’s time to make out your income tax. Their shares are called units, and they make regular distributions. It is a mistake to confuse these with dividends, because with PTPs, the payouts are considered returns of capital. From a tax standpoint, RoCs go to reduce your cost basis (what it looks like you paid for the units), so you don’t pay tax on that money unless you hold the units long enough to reduce your cost basis to $0.
Not that you avoid tax. In fact, these complicate tax, because the partnership has to issue you a K-1, which says in essence: “here’s your share of the tax liability based on how we did.” Often the K-1s don’t become available until very close to April 15, and you can almost guarantee that they will issue a revised K-1 as soon as you file your taxes. And if you sell the units, of course, since the returns of capital lowered your tax basis, from the IRS standpoint you made a big taxable gain.
If you can tolerate the tax headache, PTPs can be a good way to invest in energy. They pay you regularly. Like shares of any company, it makes sense to research them. What is a bad idea: buying PTPs in a traditional tax-deferred retirement account. I don’t fully understand how it works, but evidently they can cause havoc leading to your IRA having to file a tax return as if it were a person. Best to just keep PTPs out of your IRA.
LGCY is a PTP.
ETBs (exchange-traded bonds)
Most corporate bonds aren’t sold on a market like stocks. Most are held in brokerage inventories after their issuance. For the individual investor, it’s a little difficult to just buy these bonds, and very difficult to buy them sensibly. Not impossible, but harder than just buying stocks. For one thing, most bonds are sold in multiples of $1000 par value, so non-rich people have a tough time diversifying. This is why bond funds exist, although I greatly dislike conventional open-end bond funds. All the flaws of a stock fund, all the limitations of bonds, and all the weaknesses of conventional mutual funds rolled into one unattractive little package. ETBs are another way to invest in the bond sector while avoiding the crappiness that is conventional bond funds.
Because most have a par value of $25, ETBs are more accessible. However, these aren’t pooled investments. They are individual securities. They can appreciate, deteriorate and fail entirely, in which case you will probably get nothing. If a bond is trading at a ridiculous discount to par, with a correspondingly incredible yield, I’d bet that there’s serious underlying trouble and the odds are high you won’t see that next payout.
PPX is an ETB.
REITs (real estate investment trusts)
These got a very bad name in 2008, and for good reason: some went to zero. They trade like stocks. They often pay nice yields, and if bought well, so much the better. This is because they might best be described as a pooled investment that is required to distribute most of its gains to shareholders.
The hangup is obvious to anyone who watched them bleed out in 2008-09: if their assets drop in value, or stop performing (sending money), the value and distributions will drop. To buy a REIT without a full understanding of where they invest their money is asking for trouble; hell, it’s prostrating oneself and pleading for trouble. For example, what if it turned out a REIT was mostly in outlet malls? How many outlet malls have you seen lately that are half empty, pathetic shells? That might be why it’s so cheap. But, you might rejoin, the yield is currently 17%? That’s literally incredible. People are dumping that because they do not believe they will be paid that 17%. They’re probably right.
SPG is a REIT.
Preferred stocks
In general, these are classified as fixed income securities (the insider way to say ‘bonds’), though they are neither bonds nor common stocks. I would describe them as stocks lacking some common stock characteristics and adding some bond-like characteristics.
While you might get some capital growth from preferreds if you buy well, the dividend is the main reason for the play. Preferred stock is also senior to common stock in the pecking order for dividend payouts if the issuer comes up short on money to distribute, though junior to bonds. You won’t get proxy ballots for preferred stock; the shares are non-voting, so you don’t get to annoy the company by voting in favor of goofy or quixotic shareholder initiatives. Preferreds come in many flavors, and if you do not check into a given issue to find out exactly how it works, you’re making a mistake.
My own drag with preferreds is that my brokerage, Fidelity, uses a different ticker convention than the NYSE (or at least it did the last time I futilely attempted to place a trade for a preferred). Very uncool.
AHT.PE is a preferred stock.
The Editorial Maverick 