I typically invest in individual stocks, but I do hold a couple ETFs. Instant diversification has its pluses, especially when you’re looking at a more passive investing approach. With that said, if you are going to invest in a fund whether it be a mutual fund, exchange traded fund (ETF), closed-end fund (CEF) or some other variety of fund, it is very important that you look at the fund’s performance against the index it is attempting to match or beat.
If you’re investing in a managed fund, like a mutual fund or a CEF, you’re going to pay a fee for a team of fund managers to trade and/or use a variety of financial instruments for you. The goal is to use the team’s expertise and skill to bring you superior market returns. To hear more about this visit a previous blog entry here.
Clearly you do not want to pay a management fee to a company that under-performs against their index. If they can’t meet their benchmark, then you might as well buy the index or a low cost ETF that simply looks to match the index. How do you know whether or not a fund is performing well against its index?
In today’ investment world you’ll be told a million different things. You may see a variety of Lipper Leader scores, which are supposed to guide you to making the best investment decision or you may read a variety of literature that attempts to sell you how the fund is made for success. Don’t get confused by this wall of information. It doesn’t take a finance degree to figure out if you’re looking at a fund with a good track record.
I’m going to use the Dow 30 Enhanced Premium & Income Fund (DPO) for this example. It’s a Closed-End fund, which means it trades like a stock.
Here I am individual investor looking at DPO…should I invest in it? Well where do I start?
First, what exactly is this? It’s a fund that holds the 30 stocks that compose the DOW, plus the managers are using financial instruments like options to gain some additional exposure and hopefully come out further ahead than if it was just the DOW 30. Okay, so they’re going to invest in the Dow Jones Index and use some fancy finance tools to leverage and hopefully beat the market.
Second, how much is this going to cost me? I understand the trading fee, which I would pay for any other stock, so I don’t concern myself much with that. What does concern me are the management fees. What am I going to incur to simply hold this investment annually? I look at fund data and see that annual management expenses will be .88% and other expenses will be .21%. Therefore, I’m going to be out 1.09% of my initial investment annually, if I invest in DPO.
Third, before I look to compare performance of the fund to performance of its benchmark index I’ll look at its dividend payout and see what the current yield is. It turns out that DPO has a yield of 8.57%. On face value that catches my attention. I like high yields so I’m interested, but also a little cautious. I’ll look at the index DPO is up against (The Dow) and see that the Dow is paying about 2.33% in dividend yield. Therefore, DPO is about 6.24% higher.
Fourth, I’ll glance at the Net Asset Value figure to see whether or not this fund is trading at a premium or discount to its actual value of investment holdings. DPO is currently showing a 3.03% premium. (I like it best when the company selling the fund actually provides a chart to show NAV in terms of history. Then I can see whether or not this premium or discount is high or low in historical terms).
Lastly, now I’m ready to see how this fund has stacked up against its index, the Dow Jones Industrial Average. I’ll compare DPO against ^DJI and look at multiple years (FYI…You can do this very fast and easily through the Interactive chart feature on Yahoo! Finance).
Here is what I see in terms of DPO’s performance compared to the Dow in terms of stock price appreciation.
2011 YTD: +8%
From the start of 2011 until today the DPO fund has been handily outperforming the Dow Index. It is not only beating it in terms of price appreciation, but its yield is vastly superior. From 2010 to present and from 2009 to present the fund underperformed in price against the DOW, but it would have made up that ground with its superior dividend yield. We’ll call ’09 and ’10 a wash. In 2008 the fund go creamed. My guess is that the managers were hammered hard when the market took a steep down-turn in the latter part of the year and the leverage that they were using came back on top of them.
In summary this is what I see: A fund that seems to be able to match or beat the market in normal market conditions and a fund that will take additional trauma if markets move south fast. The dividend yield of DPO has a positive variance of 6.24% compared to the dividend yield you would earn if you just held a Dow Index fund, but in reality you need to subtract the 1.09% management fees, too. With the management fees your positive variance is 5.15%.
Should you buy this fund or buy a low-cost fund that is designed to mirror the Dow? I would say that it really depends on your needs.
Again, there are many more funds and indices than the 2 considered here, but think about it in terms of what’s going to benefit you most. If you hold that both these funds are going to bring comparable returns in the future, then do you need a quarterly distribution or not? DPO is going to beat the regular index all day long in terms of distribution, but what are you going to use that for? If you don’t have any need, then maybe your quest for a high-yield is misguided in this situation. Maybe it’s the index that’s going to be better positioned for you as an investment in the long-run.
(Note – Information about DPO was mainly found via the fund’s website…I’d recommend doing the same for other specific fund research.)