The Hidden Secret Behind These High-Yield Passive Income Favorites

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

Recently, closed-end funds have gotten a lot of hype because of their high distribution yields. However, there are several things every investor considering these passive income favorites needs to know about closed-end funds before buying shares. Here are those hidden secrets.

1. High yields are coming from funds paying you back 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 investor capital. Unfortunately, it’s often this third category that pushes a closed-end fund’s yield to attractive levels — and all that means is that you’re paying management fees to get your own money back.

Take Aberdeen Global Dynamic Dividend Fund (NYSE: AGD) as an example. It holds some of the best-known stocks in the market. But those stocks don’t yield anywhere near the fund’s distribution yield of 8.3%.

So how does the fund pay out that much passive income? It returns shareholder capital to supplement the dividend income it receives. From November 2021 to April 2022, more than half of the $0.39 per share in total distributions Aberdeen Global Dynamic Dividend made represented return of capital. That makes the yield artificially high and can mislead shareholders who don’t realize they’re just getting back the money they had previously invested.

2. It can be less expensive to buy the underlying stocks yourself

Many closed-end funds invest in ordinary stocks you could purchase yourself. Yet, because closed-end funds trade on exchanges and don’t include provisions that allow investors to buy or sell shares directly with the fund companies, fund share prices can be well above or below the underlying value of the investments they hold.

For instance, Gabelli Equity (NYSE: GAB) invests in perfectly ordinary stocks, with top holdings including Deere, Mastercard, and Berkshire Hathaway. However, the closed-end fund uses leverage to generate more income to support a distribution yield of nearly 10%. For this high yield, investors have been willing to pay 20% more than the true value of the investments Gabelli Equity holds.

Closed-end funds can trade at premiums for a long time, but those premiums usually go away. When that happens, fund investors can lose money even if the investments the fund holds go up in value. That’s a slap in the face to those seeking 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 hold their shares. However, closed-end funds typically have much, much higher expense ratios that sap the value from your investment over time.

For instance, the Gabelli Equity fund charges an annual expense ratio of 1.37%. Aberdeen Global Dynamic Dividend weighs in at 1.18% per year. And you can find some closed-end funds that charge 2% or more annually. Regardless of the distribution yield, it’s hard to generate enough outperformance to pay those high fees.

Let the passive income investor beware

Closed-end funds have some attractive characteristics, but there are some 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’re truly making good on their promise to shareholders.

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

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