Is This a Smarter Play on the Dow?

When it comes to investing, keeping things simple has a lot of appeal. That's one reason the Dow Jones Industrials (INDEX: ^DJI) are so popular: It may not be perfect as a market benchmark, but it's easy to understand. That in turn explains why the Dow-tracking ETF SPDR Diamonds (NYS: DIA) have gathered more than $11 billion in assets under management -- it's a simple way to get exposure to all 30 stocks in the Dow in a single package.

Sometimes, though, it pays to get a little more complicated. That's why I want to look at two alternative Dow-focused investments that offer a twist on traditional investing, in the hopes of discovering a superior play on the century-old market measure.

Adding bells and whistles
As fellow Fool Brian Richards touched on last week, Nuveen Investments has two closed-end funds that use the Dow as a starting point. The Dow 30 Premium & Dividend Income fund buys all 30 Dow stocks in the same proportion as the average. But it does a couple of things differently. First, it pays a dividend of about 7.6% that greatly exceeds even the highest-yielding stock in the average, thanks to a managed distribution policy that taps shareholder capital when necessary to finance dividend payments. Second, it uses a covered-call option strategy to generate some of that income.

Nuveen's other fund, Dow 30 Enhanced Premium & Income, goes even further. In addition to writing covered calls, the fund can also use derivatives to boost its overall leverage. As a result, the Enhanced Premium fund does a better job of retaining full exposure to potential gains and losses than the Premium & Income fund. Under certain circumstances, the fund gives you even more exposure than the unadjusted Dow.

How they've done
Covered calls are a commonly used method for generating more income from a portfolio. The trade-off is simple: You get to keep whatever premium you receive by selling the call options, but with the risk that if the share price rises beyond the strike price on the option, you'll miss out on additional appreciation in the stock.

Leverage-enhancing derivatives, on the other hand, have a mixed performance. Used to excess, they have led to big long-term tracking errors for highly leveraged ETFs pegged to daily performance. For instance, the bullish ProShares Ultra Dow 30 (NYS: DDM) has lost 11% of its value in the past five years, while the bearish ProShares UltraShort Dow 30 (NYS: DXD) has posted a whopping 66% loss.

For Premium & Dividend, the covered-call strategy has resulted in fairly good performance in net -asset value terms. In general, the fund has come close to matching upside performance in recent years while avoiding the full brunt of the Dow's 2008 loss. For Enhanced Premium, the additional leverage has made returns more volatile, with bigger losses in 2008 but larger gains during the subsequent recovery. Overall, it hasn't suffered the same fate as daily return-targeting leveraged ETFs.

Are these closed-ends for you?
One thing to remember about closed-end funds is that actual returns on the shares don't match up with the net-asset value returns. Share prices jumped way faster in 2009 only to languish behind NAV performance in 2010 and 2011. Since you can't cash out at NAV, you have to be ready to accept whatever premium or discount to NAV happens to apply when you want to sell.

Right now, though, both funds are available at a discount to NAV. That's fairly rare, as the funds have traded at premiums during long stretches of their histories. If you think that could happen again, then you could get some extra returns compared to the Dow's performance. However, you'll have to pay a fairly high expense ratio to get access -- currently around 1%.

Closed-end funds aren't for everyone. But if you're looking to invest in the Dow but want a different angle than just a plain-vanilla ETF, these Nuveen offerings are worth a closer look.

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At the time thisarticle was published Fool contributor Dan Caplinger always searches for smarter ways to play. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy makes you smarter.

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