Global diversification is difficult for income investors.
Most emerging market companies don’t pay great dividends – and even if they do, a withholding tax is often imposed, reducing the return to U.S. investors.
However, there are a number of international funds that pay fixed distributions to investors regardless of the fund’s performance. Used wisely, these can provide an investor with exposure to global growth markets, as well as a steady income. Here’s how…
The True Value of a Distribution
Let’s begin by looking at the Aberdeen Chile Fund (CH).
Aberdeen is a major manager of emerging market funds that offers fixed distributions on many of its offerings. One such offering, the Chile Fund, pays roughly 10% of its net asset value in dividends each year. The amount is adjusted in the first dividend of the year, payable in April.
Currently, CH pays a quarterly dividend of $0.26. Since shares are currently trading around $8, its running yield is about 13%.
This sounds great – but if we dig a little deeper into the composition of the distribution, we see one of the biggest disadvantages of this policy.
During the period of January 1 to August 31, CH paid out $0.85. Of that payout, $0.051 represented net investment income, $0.009 represented short-term capital gains, $0.221 represented long-term capital gains, and a whopping $0.57 represented return of capital.
The good news is that return of capital isn’t taxable when it’s received (it reduces your cost base, so you pay more capital gains tax when you sell the shares). But the bad news is that it’s genuinely a return of capital. The return of capital has deducted from the net assets you have in the fund.
The problem is that paying out dividends as a return of capital compounds the effect of any weakness in the market. In the case of CH, the share price has fallen from $20 to around $8 in the last three years, as the Chilean market has been weak.
Luckily, it’s possible to find funds with good yield that don’t include much, if any, return of capital in their distributions.
Buy on Discount
One such example is the Aberdeen Indonesia Fund (IF).
In 2013, IF paid $1.42 per share, of which $0.06 represented investment income and $1.36 represented capital gains – thus there was no return of capital as there was with CH. Better yet, the 2013 dividend represented 17% of the year-end share price of $8.26. IF, therefore, is potentially attractive for income seekers, though the annual dividend is likely to fluctuate.
Additionally, both CH and IF are closed-end funds, and they’re trading at a discount to the underlying net asset value (NAV) of their investments. IF, for instance, is trading at a 9% discount and offers an easy way to access the growing Indonesian market. And for its part, CH is currently at a modest 4% discount to NAV – though in the past, it has traded at a large premium, as Chile was for many years one of the most fashionable emerging markets.
One final attractive example that’s not from the Aberdeen Group is The Mexico Fund (MXF).
Each year, MXF decides what proportion of the fund’s NAV it will pay as dividends. That number is 10% for the fiscal year ending November 1, 2014, during which MXF has paid a total of $3.01, around 11% of its current share price of $27. A vast majority of that ($2.87) was capital gains, while $0.14 was net investment – meaning there was no return of capital.
MXF is trading close to NAV and offers an attractive way into Mexico, where reforms passed by President Enrique Peña Nieto are expected to spark increased growth in 2015. (The IMF projects 3.5% GDP growth, up from 2.4% in 2014.)
A Simple Strategy
Basically, if you like a market, a closed-end international fund can be a good way in, provided it’s trading at a discount. However, any premium above a few percent is to be avoided.
Next, having bought dividend-paying emerging markets funds close to or below NAV, the key question for dividend investors is how much of their dividend they can spend.
If you were invested in the Chile Fund, spending the whole of your 10% dividend would deplete your capital rather quickly. IF and MXF, on the other hand, are currently paying their dividends out of realized income and capital gains, so no depletion would occur if you spent all of the dividend.
My recommendation on balance would be to spend 5% or 6% of the capital invested each year, reinvesting dividends above this level (and selling shares if the dividend was less than this amount). In this way, you would build up additional capital in most years, and the occasional capital loss in a period like 2008, when markets fell out of bed, would be made up in subsequent years.