This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist for Boston-based Newfound Research LLC.
Yield is a perennial investment theme: As investors age, their objectives shift from one of accumulation to one of distribution. To make this transition, investors have historically tilted their portfolios toward fixed-income holdings, which offer stable income with less volatility.
However, with suppressed current interest rates and the risk of rising rates in the future, many investors have looked toward alternative income-generating asset classes for their yield needs—especially now that they are easily available in ETF packaging.
As investors evaluate the yield of these alternative income-generating opportunities, a subtle problem arises: Yield, as it is frequently reported, has a variety of definitions. So how can we compare yield in one asset class to another?
First, let’s review the standard measures that are often quoted.
12-Month Trailing Yield
This is the income yield investors would have received if they held the fund over the prior 12 months based on current net asset value (NAV). To calculate the metric, the prior 12 months’ income distributions are divided by the sum of the present NAV and any capital gain distributions over the same period.
This practice, in effect, discounts the yield figure for capital that’s no longer invested.
The potential problem here is twofold.
First, we have to qualify whether the capital gains distributions are likely to be consistent going forward. Given that these distributions usually happen once a year, we’re effectively extrapolating from a single data point—a generally frowned-upon practice.
Second, we purchase an ETF at its market price, not at its NAV. This may seem like a minor difference, but consider that many higher-yielding asset classes tend to have less liquid underlying securities—such as high yield, bank loans, emerging market bonds, etc.—that can cause price and NAV to deviate considerably.
As an example, in January 2009, the iShares JPMorgan USD Emerging Market Bond ETF (EMB | B-58) traded at a 4.29 percent premium to NAV, and the SPDR Barclays High Yield Bond ETF (JNK | B-68) was priced at a 3.98 percent premium to NAV.
Distribution yield takes the most recent distribution—whether that’s income, capital gains or some other special event—annualizes it and divides by the current NAV. The big difference is that distribution yield cares not for how the distribution was generated, just that it was generated.
Depending on how distribution yield is calculated, however, it may be highly sensitive to special or lumpy distributions, painting an inaccurate picture of the actual annualized yield we should expect.
Weighted Average Yield-To-Maturity
Relevant to funds holding fixed-income securities, weighted average yield-to-maturity looks under the hood to the underlying fund holdings to take into account bond pricing dynamics.
Yield-to-maturity is the anticipated rate of return for a bond if it is held to maturity, which will take into account appreciation or depreciation that may occur when a bond is purchased below or above its face value. For callable bonds, yield-to-worst is used instead; yield-to-worst is the lesser of yield-to-call—which assumes a bond bought at a premium will be called—and yield-to-maturity.
Unfortunately, while yield-to-maturity may give a very accurate value for bond funds, it fails to be usable across other asset classes. Furthermore, the fund structure of many bond ETFs means that bonds are rarely held until maturity.
30-Day SEC Yield
This yield metric was developed by the Securities and Exchange Commission in an effort to provide a fairer comparison across bond funds. The figure approximates the yield an investor would receive assuming that bonds within the portfolio are held until maturity. The measure also assumes the reinvestment of all income, and accounting for fees and expenses of the fund.
The formula is vague enough, however, that it could be applied to dividend equity funds. Still, while iShares calculates this figure for its dividend equity funds, few other fund families do.
30-day SEC yield may be a very effective tool for placing bond funds on even ground for analysis, but it is not widely reported across other income-generating asset classes. Furthermore, due to its short-term nature, it may be highly sensitive to lumpy distributions that may occur.
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.