The Answer Guy

The risk in high-yielding stocks and what's so special about low-cost funds.

By George Mannes, Money Magazine senior writer

(Money Magazine) -- Question One of my relatives brags about owning stocks that pay dividends of around 10%. I'm afraid there's some risk here. What is it? - Ken Nimmo, Buffalo Grove, Ill.

Answer High-yielding investments, particularly the ones that relatives brag about, always come with a catch. The chief one here is the riskiness of the underlying shares. A fat dividend doesn't do you much good if the stock's price tanks.

Exhibit A is one group of investments on the list that you e-mailed: Canadian energy trusts producing oil and gas. Their shares sank last fall on news of proposed changes in tax treatment.

PrimeWest Energy Trust (ticker: PWI), for one, yielded 16.6% as of December, but its total return for the year was  26.5%. Other risks to these trusts: falling oil prices and depletion of reserves, says T. Rowe Price fund manager Charles Ober.

Your relative also holds mutual funds that sell options to buy stocks they own, a strategy known as writing covered calls. This works fine in a flat market but limits gains in a bull market (and protects only a little in a falling one).

Plus, the more a covered-call fund pushes for income, says Wachovia Securities analyst Mariana Bush, the greater the threat to its asset value.

Yes, these securities yield more than a blue chip. But given their risk, they'd better.

Question People say you should invest in low-cost mutual funds. But expenses are already deducted from published returns. So if two funds both return 10% this year, what does it matter that one fund's expense ratio is 0.23% and another's is 0.85%? You don't get a check for what you're supposedly saving. - Susan M., Portland, Ore.

Answer Ah, but what about next year's returns and the year after's?

Because the higher-expense fund deducts more from your assets each year, its investments have to outperform those of the cheaper fund to give shareholders the same net return.

Over the long run, that can become a tough hurdle to clear. That's why a low expense ratio improves the odds that a fund will do better than its peers. A portfolio manager may have his or her ups and downs as a stock picker, but low expenses will consistently give a fund a leg up on its costlier competitors.

How low is low enough? Russel Kinnel, Morningstar's director of fund research, suggests using low-cost leader Vanguard as a benchmark. If a fund you like has expenses within 0.2 percentage points of a similar Vanguard fund, that's a good sign. "Screening for low-cost funds," says Kinnel, "is one of the easiest and most important ways to get to a good fund."

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.