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Don’t believe anyone who tells you there’s such a thing as a safe investment. Truth is, every asset—from Treasuries to houses to dividend stocks—involves risk.
The “safest” investment, according to the Financial Industry Regulatory Authority (FINRA), is a short-term US Treasury bill. You lend the government $100, say, and you’ll get $105.17 back in a year. Not bad.
But there are some caveats:
- Short-term Treasury rates fluctuate, and the Federal Reserve has said they’ll try to get them lower later this year.
- In a truly apocalyptic disaster, you might find that the Federal Reserve doesn’t pay your money back. In fact, you might find that money itself is worthless.
That second point might sound silly, but I’m pushing the boundary here to highlight the point that nothing in life is risk-free. When investors talk about “risk-free returns,” like with Treasuries, they’re assuming tomorrow will look like today. But it may not.
For this reason, we have to accept that no matter where we put our money, there’s a chance of losing some.
Inflation Risk Is Far More Dangerous Than People Think (Especially Now)
What about cash, supposedly the ultimate safe investment? That’s even riskier. Due to inflation, if you saved $100 in cash five years ago, it’s worth $78.80 now.
The reason for this is that our current 3.5% inflation rate devalues money by that much from just a year ago, but of course inflation ate into money’s value the year before that, and before that, and before that … you get the idea.
In other words, not even cash is safe.
I’m not writing this to worry you! Instead, look at it this way: Your wealth is yours to master and turn into more wealth. The key is to embrace risk and put a bit more focus on the rewards investors get for taking it on.
Consider, for example, how someone who bought short-term US Treasuries five years ago—shown through the iShares Short Treasury Bond ETF (SHV) in orange below—would have done compared to an investor who bought the SPDR S&P 500 ETF Trust (SPY), the benchmark S&P 500 index fund (in purple).
Low Risk, Low Returns
That period included a pandemic, an inflation spike and all kinds of other pandemonium. Even so, stocks crushed short-term Treasuries. It just shows that letting fear rule too many of our investing decisions is more detrimental than we realize.
Sounds reasonable, you might be thinking, but surely there’s a way to ease stock volatility without sacrificing much in returns and ensuring my money is there when I need it.
This concern is perhaps the most common one among individual investors. And (of course!) Wall Street has an answer: the target-date fund.
Here’s how it works: Let’s say we want our money available in 20 years, so we buy a fund with a target date 20 years out, put our money in, keep investing and ride the wave.
It helps to show this through a real-world example, so let’s put together a little scenario.
Let’s say an investor back in 2003 wanted to retire in a bit more than 20 years, so they bought the (then) newly launched Vanguard Target Retirement 2025 Fund (VTTVX).
Our investor is drawn by the fund’s set-it-and-forget-it nature. They also find VTTX appealing because over time it will lower their exposure to stocks and shift to bonds to increase safety and ensure their money is there when they retire. Plus the fund is cheap, with a fee of just 0.08% of assets.
Sounds great, right? Well, not so fast.
Target Date Funds Underperform
With VTTVX (in orange above), our investor’s current value would be less than half of what it would’ve been if they’d invested in the stock market. A $100,000 investment in VTTVX would now be around $261,200, while the S&P 500 index fund produces about $613,100.
In other words, fear cost them over $350,000—the cost of a house or a Lamborghini.
True, SPY’s dips have been worse than those of VTTVX, but this is an illusion. If we zoom in on times of stress, like 2020, we see that VTTVX’s strategy didn’t help much.
VTTVX still fell 20% during the crash, which is better than 30% drop in the S&P 500. But the index also recovered faster. So VTTVX holders were spared the pain of losing an extra 10% of their gains, but they also suffered the pain of a slower recovery.
In fact, their recovery was never fully finished, as VTTVX has underperformed since the COVID crash.
There’s still one issue here: liquidity.
In 2023, VTTVX paid a 4% dividend, while the average S&P 500 stock pays about 1.3%. So a lot of investors point to target funds as a great income option. Sure, you sacrifice profits, goes the thinking, but you have more cash flow as compensation.
Not exactly. At least not when you compare VTTVX with the asset class every investor should be looking to for long-term gains and high dividends: closed-end funds (CEFs).
Below we see the total returns of VTTVX (at the bottom, in purple) versus those of three CEFs that focus on large cap stocks: the Adams Diversified Equity Fund (ADX), in orange, Central Securities Corporation (CET), in blue, and General American Investors Co. (GAM), in green.
As you can see, all three have crushed the target-date fund:
CEFs Outperform
CET, in particular, really took off, thanks to the magic of compounding stemming from the fact that it did much better than its peers during the Great Recession. From the start of 2008 to the start of 2015, CET gained 53.3%, while ADX and GAM returned around 35% each.
Consider also that these funds have paid out over 7% in dividends on average during this period, and you can see why target funds don’t make much sense. They offer less cash flow, lower returns and not much less risk.
The final word is that if you’re looking to grow your retirement savings, target funds may seem compelling, but their low-risk approach also means there’s a high chance of low returns, which, of course, nobody wants.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Steady 10.9% Dividends.”
Disclosure: none
Don’t fall into the trap of thinking you can’t beat the market. It’s total nonsense—and that goes double if you look outside stocks, to other assets.
Consider preferred stocks for example—they’re “bond-stock” hybrids that trade on an exchange, like stocks. But like bonds, they trade around a par value.
The best part is the income. Our favorite way to buy preferreds—through actively managed (we’ll come back to that in a second) closed-end funds (CEFs)—gets us yields of 7%+.
And select preferred-stock CEFs trade below their net asset value (NAV, or the value of their portfolios) today—with some of those discounts reaching well into double-digits.
Finally, preferred stock CEFs beat their benchmarks all the time, a fact we’ll see in action momentarily.
Preferred-Stock CEFs: Proven Benchmark Beaters (With Big Yields, Too)
Academics call the idea that you can’t beat the market the “efficient market hypothesis.” In 2013, Eugene F. Fama, the economist who first made the hypothesis in its modern form, won the Nobel prize for his work on this theory. He won it alongside Lars Peter Hansen, who did a lot of the heavy math supporting Fama’s hypothesis.
Here’s where this story gets weird. Fama and Hansen shared the Nobel prize with a third winner that year, Robert Schiller, the Yale economics professor who has argued markets are not efficient and often create bubbles, as we saw during the dot-com crash of the 1990s and the subprime-mortgage crisis of the 2000s.
How can economists who ardently disagree with each other win the same esteemed prize in the same year?
It shows just how messy investing can be. In fact, markets aren’t fully efficient, and we often see fund managers beat their benchmarks for a long period of time. Preferred-stock CEFs are a perfect example of this.
If we look at those that have had a lifespan of a decade or more, they’ve all beaten the passive iShares Preferred & Income Securities ETF (PFF) in the past decade.
Preferred Stock CEFs Outperform
Ycharts
I know there’s a lot going on in this chart, but we can see that PFF, at the bottom, is far behind even the worst-performing of the preferred-focused actively managed CEFs, the Nuveen Preferred & Income Opportunities Fund (JPC), which had a much greater 62.9% return.
At the top end, the John Hancock Premium Dividend Fund (PDT) nearly doubled the index’s performance.
Also, it’s worth reiterating the massive income streams these funds offer, with yields of 8.5% on average, versus PFF’s 6.5%. And then there are those discounts—another inefficiency we contrarians can exploit.
Preferred Stock CEFs
Contrarian Outlook
Of these preferred-stock focused CEFs, over half sport discounts, and the Flaherty & Crumrine Preferred Securities Income Fund (FFC) has the deepest discount of them all, with a market price over 11% below its portfolio value.
That’s probably because of its relatively low (for a CEF) 6.9% dividend yield. But it also means investors who buy now and wait for the market inefficiency to end can earn some capital gains on top of that impressive income stream.
And don’t think FFC won’t trade at a premium eventually: it has done so many times in its more than 20-year history. As recently as 2021, the fund was trading for more than its assets were worth.
For a bigger yield, look to the John Hancock Premium Dividend Fund (PDT) and its incredible 9.1% payout, which also trades at a rare discount.
PDT once traded at a more than 20% premium, and double-digit premiums haven’t been unheard of in recent years. The recent selloff has driven it to its deepest discount range in a decade, and we can see in the chart above that this discount is narrowing.
Of course, we’ve seen head fakes before, like at the end of 2023, so PDT may revert back to a double-digit discount again. But that would be a reason to buy more. Just look at what would’ve happened if you’d bought four months ago, the last time PDT’s discount fell to double digits:
PDT Total Returns
Ycharts
All of this while collecting a 9.1% dividend yield! If that’s not reason to go from passive to active, then I don’t know what is.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Steady 10.9% Dividends.”
Disclosure: none