High Yield Investment of the Month again … and again … and again

by Travis Johnson, Stock Gumshoe | July 2, 2008 2:50 am

Let me just warn you up front — this is a rerun. But I calls ’em like I sees ’em, and Carla Pasternak[1] runs this same exact ad so often that I get questions about it once every few months. This is no exception — she’s been calling this particular Closed End Fund (CEF) her “Income Security of the Month” about every third or fourth month since last year. Now she’s selling it as an investment with a 24.9% yield, so the numbers change each time but precious little else does (and be careful if you’re counting on that yield going forward — it ain’t exactly a promised dividend).

This secret teaser investment remains the Korea[2] Fund, for those who are interested, and I won’t delve into trying to analyze it again, since I’ve done that a few times and my opinion hasn’t changed (though the South Korean market has tumbled alongside the other Asian markets recently … which means that any capital gains disbursed by this fund as dividends[3] at the end of the year are likely to be much lower than last year’s payout).

If you look at the chart and get the willies, do note that the huge precipitous fall wasn’t nearly as bad as some charts make it look — November of last year was when the special dividend of realized capital gains was paid out, which is why the price fell by about $16 on November 29. The price certainly has fallen, too, but not as badly as it looks if you don’t discount for the dividend.

But in case you missed it in November, and in February, here it is. I’ve made no edits below, but Warren Buffett[4] is still an enthusiastic investor in South Korea (particularly in Posco), the fund does still trade at roughly a 6% discount to NAV, and, for full disclosure, I don’t currently own KF, the EWY ETF for South Korea, or any individual South Korean stocks.

So without further ado … here’s the rerun:

Carla Pasternak sends out an email ad for her High Yield Investing service every month, highlighting her new “Income Security of the Month.”

And I was just checking out her latest one, for February … when it started to sound a little bit familiar, even to the Gumshoe’s tin ear. This is a melody I’ve heard before …

So this is for a closed-end fund that invests in foreign stocks, particularly in a country whose stocks are, on average, trading at a 30% discount to the PE of the US Stock Market (according to S&P). It has a mammoth average “yield” of 22.1% per year over the past five years.

Sound familiar? Yep, this is the Korea Fund again — the same one she teased as the Income Security of the Month back in November[5], and if I remember correctly she put it out there at some earlier point as well.

You can read my earlier post about the Korea Fund[6] if you like, my opinion hasn’t changed. There’s nothing particularly wrong with the fund — it’s not that expensive, and Korea is certainly an interesting country for investing currently (especially after the recent dip).

I would just reiterate my main points: The payments spun off may be treated as dividends, but they are really capital gains that accumulate throughout the year. There have been big one-time payments at the end of the past two years when the fund had huge capital gains, but even if you like Korea as an investment it might be dangerous to assume any kind of “dividend” income like this going forward.

And there is a lower-cost index alternative for Korea if that’s your main interest and you don’t want the “manager risk” of having someone try to beat the index. The performance of KF and EWY (the iShares ETF for South Korea) has been quite similar for the past two years, if you account for the gyrations of the KF dividends, but EWY would certainly be easier to manage for taxes.

KF does trade at a moderate discount to net asset value of 6% or so — which is about middling for a closed end fund — back before there were other easy ways to invest in Korea it used to trade at massive premiums, sometimes over 100%, but those days are long gone and it has generally been at a 5-10% discount for much of the past couple years.

For those who don’t know closed end funds well, the risk in buying KF for that reason (the discount) is that the discount is not that likely to ever disappear, and if Korea goes out of favor rapidly the discount might widen significantly — the China[7] A Shares CEF from Morgan Stanley, for example, traded at a premium for a while but now trades at a massive discount of about 30%.

That’s the extreme, but remember that in addition to sometimes letting you invest in sectors at a discount, closed end funds also, by virtue of their ability to trade at either a premium or a discount on the open market, can often have outsized moves that magnify the movements of the underlying market. If investor enthusiasm sparks suddenly for Korea or for this management team, it might run to a premium of 2 or 3%, for example, but if Korea passes restrictive rules about foreign stock ownership, or their market collapses for some reason (not predicting either of these, they’re just examples), then the discount could run to 15-20% overnight as investors try to rapidly sell their shares. Index ETFs usually (thought not always) are a bit more stable in trading very close to their net asset value.
The big “dividend” payments, by the way, are the reason that you’ll see massive drops in the share price at the end of last year and 2006, since the payouts were taken out of the share price. These funds are often not good candidates for dividend trading strategies the way that individual stocks can be. If you bought the shares just before the ex div date back in November, for example, you’d be out of luck, since not only do you just get to pay taxes on a big dividend that didn’t actually represent capital gains you had enjoyed (essentially, you would have bought shares for $50, they sent you $20 and you had to pay taxes on the $20 in income and the price of the shares went immediately to $30, then proceeded steadily lower … all numbers rounded for simplicity).

I certainly don’t mean to be particularly hard on the Korea Fund — I have owned this one in the past, though not recently, and compared to many closed end funds it has relatively reasonable expense ratios and it has at least kept up with its underlying index (believe it or not, both of those qualities are somewhat rare in closed end fund world). The premium/discount ratio has been relatively stable, which is generally a good thing. If I were interested in investing in Korea right now I’d probably go with the iShares ETF, but that’s just me (I actually sold that ETF about six months ago because Korea didn’t look cheap anymore to me, but it’s now looking like it might start to get a little cheaper).

Wow, that was a lot of writing to share with you a teaser that we uncovered months ago. Is that Gumshoe a talent or what?

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