MAX,

I recently received an email solicitation for the 'High Yield Investing Newsletter,' featuring a mysterious diversified fund called The Korea Fund (KF) which sports a whopping 18.4% dividend with a 34 .4% projected yield! Is this even possible

Mike
Los Angeles

Dear Mike,

It is, in fact, possible for a diversified fund to yield 18.4%. But of course, there is a catch. This kind of yield is best avoided. The income newsletter's marketing department has clearly opted to transform lemons into lemonade. So let’s get to the bottom of this allegedly attractive investment opportunity.

There really is no such thing as a free lunch when it comes to investing. When stocks pay dividends that beat the S&P 500 (which is currently yielding under 2%) by such a large margin, there is always a reason:

• The stock might have lower growth prospects than most companies (regulated utility stocks are a good example.)
• The business has mandatory high payouts, much like a mutual fund (we often see this with real estate investment trusts)
• The company is simply issuing a sizable one-time dividend (as Microsoft did in 2004).
• The stock has fallen on hard times, or faces an uncertain future (as Merck did in 2006).
• The dividend payouts might be unsustainable or likely to be cut (like General Motors and Ford in recent years).

Sometimes, über-high dividend prospecting works out. Just ask the investors who bought Merck last year. More often than not, though, investors wind up with a cut dividend and a sinking stock.

Mutual funds yields can be confusing. Since a diversified stock mutual fund owns dozens of individual stocks, it's very unusual for one to garner a steady, legitimate yield several times greater than the S&P 500 . Such oversized yields are hard to come by, especially since funds deduct their fees from collected dividends.

The problem is that yields can be inflated to appear more impressive than they really are. Strong yields make it appear as though a mutual fund is collecting steady dividends from all the portfolio’s stocks, but such buy and hold dividend collecting today nets only about 2-3% for the typical common stock investor. Vanguard High Dividend Yield Index Fund (VHDYX), for example, is currently yielding a paltry 2.68%. Funds boasting much higher yields have to be doing something else, like buying bonds or REITs, in order to juice their yields. Sometimes, that attractive yield is nothing but smoke and mirrors.

In the case of the Korea Fund, its 18% "dividend " is merely an old-fashioned capital gains distribution.

When mutual fund managers sell stock at a gain, they realize either a short or long-term capital gain. If they have no losses to offset that gain, they have to distribute the gains to the fund's investors. This distribution generally takes place near the end of the year.

If you consider such a payout a yield, then we have in fact seen "yields" of over 50%. You won’t make a dime buying one of these funds before the distribution is made, but you will get slapped with a big tax liability if you own the fund outside of a tax deferred account when it happens. This payout is a mere accounting gesture: a fund valued at $10 per share might pay a $5 dividend . Shareholders wind up with twice as many shares at $5 each, but now they owe tax on that $5 phantom gain. The real gain was made by owning the fund as its value rose to $10 a share. Most shareholders want to avoid large capital gain distributions. In fact, fund companies often hide them in order to avoid a massive run for the exits.

Because emerging markets have performed so well in recent years, many of the stocks in the Korea Fund’s portfolio are way up - with average increases of 100% or more. Believe it or not, this is normal. What is abnormal for a hot emerging markets fund this year is the fund's recent fund management change. The new management has a different group of stocks it finds attractive, so it sold most of the old holdings. Since these old holdings had gone way up in recent years, the fund is now realizing significant taxable gains that must be distributed to its shareholders.

Buying this fund today is buying somebody else’s tax liability. You're also getting a new manager, so the past performance touted in the income newsletter pitch is not that relevant.

The Korea Fund (KF) is a decent, low-fee, single-country, closed-end fund whose managers almost certainly knew nothing about their fund being featured in an ad for an investment newsletter with an aggressive marketing campaign. Ironically, the fund recently sent a letter to its investors, in which it acknowledged its shareholders' displeasure at receiving such a large one-time dividend (you can research the historical dividends here). The fund's management indicated it would take steps to prevent such big distributions from occurring in the future. In fact, the true dividend yield you’d get from owning a fund like this is about 1% per year – nothing to live off of in retirement, that’s for sure. Such low yields and high risk make this fund more suitable for an aggressive growth portfolio, not an income portfolio anyway.

Thanks for the question.

MAX

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