The definition of yield is simple, but there are many ways that it can be calculated.
Clients are asking a lot of questions about yield these days. Why is it so low? How much can I earn on my "safe money"? How much are my stocks and funds paying in dividends?
When a client asks for the yield on a particular investment, what is the answer? When you are comparing funds, are you using common measurements? Do you ever wonder why the yield on a fund is radically different from the last time you checked? Do your clients wonder why the yield they see quoted isn't the same yield that they experience?
Dividend-paying companies are not necessarily inherently better than companies that reinvest their profits. In fact, there may be more upside potential for companies that are plowing the earnings back into research or expansion. However, there is no getting around clients' recent interest in dividend-paying stocks and funds as a reaction to market volatility and concerns about the future.
Although our firm takes a total return approach to investing, we also collect yield data on the funds that we use. This allows us to reassure clients who are concerned about the cash that their portfolios are throwing off. It also helps us keep track of interest and dividend income, which will allow us to reposition portfolios as necessary when tax laws change. In 2013, the 3.8% Medicare tax will take effect for clients with adjusted gross incomes of $200,000 for individuals and $250,000 for joint filers, and we want to be ready. In addition, dividends may be subject to a higher tax rate when the current tax laws expire.
We use mutual funds and exchange-traded funds for our equity positions, and until bond ladders start to make sense again, we also use mutual funds and ETFs for fixed income. It's simple enough to calculate the yield on a single bond or for a single company, but a fund may have thousands of holdings with widely fluctuating distributions. There are various ways to measure yield, and mutual funds and ETFs can have yields that vary considerably, depending on the method of calculation.
Simply put, yield is the return on an investor's capital investment. It is the percentage rate of return paid in dividends for stock or the amount of interest paid for a bond. The definition is simple, but there are many ways that it can be calculated. It's important to use the same form of measurement when comparing funds and choosing the right investments for a portfolio. There are several types of yield calculations:
This method was created and mandated by the Securities and Exchange Commission in order to provide a standardized means of comparison. It is based on the current market yield to maturity for bonds or projected dividend yield for stocks held by a fund over a trailing 30-day period, less the fund's expenses, annualized. This is also referred to as the "standardized yield." The SEC yield for money market funds is calculated by annualizing the daily income for the past seven days. It may be an accurate representation for the short term but can vary widely from a fund's actual experience.
Average Yield to Maturity
Yield to maturity is the rate of return expected if a bond is held to its maturity date. The average yield to maturity approach aggregates the yield statistics for all of the holdings of a bond fund. This method provides another standardized approach for comparing funds; however, it does not take into account fees and expenses, so the investor's actual experience will never match the stated yield.
This is calculated as if the most recent distribution stayed constant. The most recent distribution is annualized and divided by the fund's current net asset value. This may be useful for funds that have a fairly consistent payout on a monthly basis, but many funds have distribution patterns that vary significantly from quarter to quarter or year to year.
12 Month Yield
This is the yield that an investor would have received if he or she had owned the fund for the previous 12-month period. Instead of simply annualizing the most recent distribution, this is based on actual income distributions divided by the most recent net asset value, plus any capital gains from the previous year.
The advantage of this method is that it reflects the actual experience of investors instead of measuring potential yield. It also smooths out the distortions in projecting yield from distributions that may have considerable fluctuation from period to period, as in the Distribution Yield. The disadvantages are that, unlike SEC yield or average yield to maturity, the 12-month yield looks at past data and will be understated in a rising interest rate environment. It is not available for comparison to new funds until a full year's worth of data is available.
Yield on TIPS
Treasury Inflation Protected Securities present a unique problem in projecting yield since there is an unknown inflation component to be considered, and there is inconsistency in the way fund companies calculate TIPS yield. A common practice is to take the "real yield" or SEC yield and add an estimated inflation adjustment based on the Consumer Price Index. The factor that is layered on can be either positive or negative in any given period.
Using Yield Data
Different measures of yield are useful for different purposes. If short-term trading is the goal, then a method such as SEC yield with the most recent information may be useful. Twelve-month yield may give a better indication of what an investor may actually experience. The important thing is to compare investments using the same methodology. The next time you see differing yield numbers for the same fund and for the same time period, take a look at the methods being employed. They may both be accurate but with a different approach.
It goes without saying that you also need to apply risk and return filters when comparing yield among various funds. When evaluating bond funds, there is usually a very predictable difference in yield based on quality and duration, regardless of the method of computing yield.
When comparing funds with similar goals, holdings, and risk profiles, a yield analysis will allow the advisor to design a portfolio with increasing or diminishing distributions based on each client's situation. As taxation of interest and dividends changes over the next couple of years, you can add value for your clients by helping them control their exposure to taxable investment income.