The Great Yield Mirage
After I recently praised electric-utility stocks and funds that invest in them as underappreciated sources of tax-friendly, 5% dividend yields, a reader named Mathew took me to task for omitting Gabelli Utilities Fund. The fund's Class AAA shares (symbol GABUX) "currently yield a dividend" of 14%, with no upfront sales load and reasonable expenses, Mat wrote.
Obviously, a 14% yield catches the eye. Gabelli Utilities pays Mat a fixed 7 cents a month per share. That's 84 cents per year. Divide that by the fund's net asset value (NAV) per share of $5.99 and you get 14%. So there is a veneer of truth in what Mat says.
Alas, there's a catch -- and it's a doozy. The fund's true yield, based on the dividends and interest it earns minus annual fees, is actually about 1%. Where does the 14% come from? It's based on distributions that consist almost entirely of a return of capital. That literally means you're getting your own money back. The 14% yield is a mirage.
Gabelli Utilities isn't the only fund that engages in trompe l'oeil. More than 30 closed-end funds, which trade like stocks, have policies of "managed" distributions. In not one single case do these funds' earnings come close to covering the tab for their distributions.
When it comes to funds, there is widespread confusion about what yield really means. Yield is what a fund pays out in dividends or interest or both, divided by the fund's share price. Distributions refer to everything a fund disburses to investors, no matter the origin.
If a fund isn't earning 14% from dividends and interest, how does it come up with the cash to make such a large payment? It can do so by borrowing, tapping its cash reserves, liquidating fund assets (regardless of whether that's a smart investment decision) or selling new shares.
But unless a fund's holdings produce substantial appreciation, its NAV melts and melts. The concept "is kind of sketchy," says Mitch Reiner, of Capital Investment Advisors, an Atlanta firm that specializes in high-yielding portfolios. He compares the results of a managed-payout policy to the depletion of an annuity balance if you were to withdraw more money each year than the annuity earns on the principal.
In today's super-low interest rate climate, no ordinary utility fund could possibly support a 14% yield with its earnings alone. But "the average person doesn't get this," says Maury Fertig, head of Relative Value Partners, a Northbrook, Ill., firm that specializes in high-yielding investments. "People see a fund's payout numbers, a broker talks it up, it sounds great, and so they buy," Fertig says. Usually, it's to their regret.
Gabelli defends the managed-distribution concept, which it employs in several funds, as fair if you want "predictable, but not assured" payments. Helped by inflows from selling new shares, Gabelli Utilities has maintained the 7 cent monthly distribution since 2000. But it has done so at a price: Its NAV has eroded from nearly $12 per share in 2000 to the current $5.99. To make the fat distributions, the fund holds a lot of cash, which can be a drag on performance, especially when cash pays zilch.
All this said, Gabelli Utilities is not a bad fund. Over the past ten years through December 2, the fund returned an annualized 7.6%. That beat Standard & Poor's 500-stock index by an average of 4.7 percentage points per year and the typical utility fund by an average of one point per year. These figures assume reinvestment of distributions, which is of little concern to investors seeking fat yields. And lest you think I'm unfairly maligning Gabelli, I should note that many fund companies, including BlackRock, Eaton Vance, MFS and Pimco, sponsor funds with similar distribution policies.
But just because respectable companies sell these funds doesn't mean they're good products. If you want income but must preserve your principal, avoid Gabelli Utilities and similar funds.