In Search Of A Single Number
Ideally, we would have a single, easy-to-calculate number. At Newfound, our ideal list of qualities for a yield calculation would include:
- Robust to the lumpiness of distributions
- Applicable across many asset classes
- Captures all types of distributions
- Captures associated fund fees
- Captures the effect of appreciation and depreciation of bonds purchased at a discount or premium to par
So What Does Newfound Do?
Our calculation method for estimating forward yield is a blend between 12-month trailing yield and distribution yield. We take the prior 12 months’ distributions and divide them by current price.
We use current price instead of NAV in our calculations to account for the significant premium or discount to NAV that an ETF can trade at based on the liquidity of the underlying securities.
By using the trailing 12 months’ distribution history, we help smooth out any lumpiness in distributions. Furthermore, we are agnostic to asset class peculiarities. For us, a distribution is a distribution is a distribution. So this method fairly easily satisfies our first three qualities, but what about qualities Nos. 4 and 5?
Tying Up Loose Ends
ETF expense ratios are usually deducted from the dividend and interest payments the ETFs receive before they’re passed on to the shareholders. So implicit in our per-share distributions of income-generating asset classes are the fees themselves. So that covers quality No. 4
As for the yield-to-maturity issues with bonds, it turns out it’s implicit in the distribution, as well.
When a bond is purchased at a premium, the ETF’s manager will usually amortize the premium by reinvesting a fraction of the coupon they receive, in effect reducing the distribution to shareholders.
Similarly, when bonds are purchased at a discount, the accretion of the discount may result in the ETF paying more income. Through this mechanism, the distribution yield can actually approach the weighted average yield-to-maturity adjusted for fees.
What About Capital Gains?
What we haven’t addressed are capital gains, another potential misleading factor in yield calculation.
Here, the ETF structure itself helps sweep the details under the rug. Through the creation/redemption process, ETF managers can swap out low-cost-basis securities, reducing their realized capital gains.
At the end of 2013, iShares only had capital gains distributions on four of its 299 ETFs.
Realizing The Yield
The goal with any of these yield metrics is generally to evaluate and compare assets for portfolio allocation decisions. Some of the methods we discussed are only applicable to certain assets. All of the methods use historical distribution data over a certain time period to estimate the yield moving forward. But the yield was not earned unless we already made the decision and owned the asset.
Ultimately, the most important feature of the yield value used is agreement with reality. We want to base our investment decisions on the best estimate of realized yield while reducing the chances of an unrealistic estimate.
Newfound’s yield metric addresses some of the pitfalls investors can face when using 12-month trailing yield, 30-day SEC yield, distribution yield or yield-to-maturity.
Our yield metric is applicable to any asset class and, by satisfying the five rules we laid out, it allows investors to compare investment alternatives based on a yield expectation that’s more in line with how they view income generation.
At the time of writing, the author’s firm owned none of the securities mentioned.
Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.