Forget Dividend Stocks: Here’s an Even Better Way to Generate Passive Income

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OWhen the topic of passive income comes up, many investors will immediately think of dividend-paying stocks. And rightly so. The best dividend stocks can generate reliable annual income with little effort on your part.

Allow me to offer a different angle, however. Forget buying individual dividend stocks. Here’s an even better way to earn passive income.

A lesser known alternative

You probably know at least a little about mutual funds. You are probably familiar with exchange-traded funds (AND F). But there is a sort of hybrid between the two types of funds that you may not have heard much about.

Closed-end funds (CEFs) are a special type of mutual fund. The term “closed” is used because a fixed number of shares are issued in advance to raise capital. Unlike open-ended mutual funds, no new shares will be issued. CEFs are also similar to ETFs in one key way: they can be bought and sold on major stock exchanges.

Like most mutual funds, CEFs are actively managed. The portfolio managers of these funds generally focus on investments that generate exceptionally high income. More than 200 CEFs offer distribution yields of at least 5%. More than half of them have distribution yields of 7% or more.

One of the main advantages of CEFs over buying individual dividend stocks is that they are more diversified. Funds often hold a large number of holdings. In addition, CEF managers have greater access to high yield investments that many retail investors do not, including corporate bonds and favorite stock.

Some good examples

CEFs are available in several versions. You can mix and match according to your individual preferences.

Some of the funds focus primarily on bonds. For example, the AllianceBernstein Global High Income Fund (NYSE: AWF) invests primarily in corporate bonds with some government bonds as well. CEF’s distribution yield currently exceeds 8%. It also trades below the net asset value (NAV) – the sum of the fund’s total assets minus its total liabilities.

For investors interested in preferred shares, the Nuveen Preferred Securities and Income Fund (NYSE: JPS) presents itself as a potential candidate. This CEF invests at least 80% of its money in preferred stocks and other income-generating assets. The fund’s distribution yield is almost 7.8%. It trades at a discount to its net asset value of more than 7%.

A number of CEFs have a large basket of dividend-paying stocks. The Aberdeen Global Dynamics Dividend Fund (NYSE: AGD) is a good example. This CEF invests in dividend-paying stocks across a wide range of sectors. It increases the income generated by the use of leverage (borrowing). The fund’s distribution is currently yielding over 8.3%. It is also trading at a discount of more than 11% to its net asset value.

Maybe not totally forget about dividend stocks

There are plenty of other CEFs to consider beyond the aforementioned examples that offer juicy returns. These funds can be a great way to generate significant passive income.

The biggest downside to CEFs, however, is that you have to pay an annual fee. Many of the top CEFs have expense ratios around 1%. But the extra passive income they can generate often makes the fees worth the extra cost.

Due to these fees, however, you may not want totally forget the individual stocks with dividends. Some dividend-paying stocks have yields just as attractive as those of the best CEFs at no extra cost. There are several large dividend-paying stocks that investors can buy and hold safely.

However, not all investors have the time to research and buy enough of these stocks to be well diversified. If you fall into this group, CEFs might be a better option for generating passive income.

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Keith Speights has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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