Beware Different Kinds Of ETF Yields

Knowing what ‘yield’ even means is a crucial requirement for ETF investors.

Investors continue to reach for yield in the current zero-interest-rate environment. But before you chase ETFs with the highest “dividend yields,” make sure you know exactly what yield you’re looking at.

Yield is one of most popular data points, but it’s also one of the trickiest because there are many different types of yields often displayed for the same ETF, causing confusion for investors.

Adding to the complexity, same-name yields can also be calculated differently. For example, ETF.com’s calculation of “distribution yield” differs from the way iShares calculates its, which I’ll explain in a bit.

ETF.com Analytics displays two different ETF yields on our equity fund reports: distribution yield and portfolio yield. It’s imperative to understand the differences. If you don’t, it could lead to poor investment decisions based on a perceived large ETF “dividend yield” that may not present an accurate picture of future dividends.

Furthermore, understanding the reasons behind the distributions can also tell you how those distributions are taxed, since qualified dividends and income are taxed at different rates.

Distribution Vs. Portfolio Yield

Distribution yield, displayed on our reports’ “overview” tab, is the actual distribution shareholders in the ETF received during the past 12 months relative to the fund’s current NAV.

We calculate this yield by summing up all distributions per share over the past 12 months (including income, and short- and long-term capital gains), and dividing that by the ETF’s current net asset value (NAV), net of fees.

(iShares calculates distribution yield on its funds by annualizing the most recent fund distribution and dividing that figure by NAV).

The portfolio yield, displayed in the “Fit” tab, gives you the trailing 12-month (TTM) weighted average yield of the ETF’s underlying holdings. We calculate this yield by taking distributions paid from each underlying security over the past 12 months and dividing them by the current, respective share prices.

Portfolio yield is somewhat of a simpler concept to grasp than distribution yield. Assuming no changes in the underlying constituents, share prices or their distributions, this is roughly the yield you can expect in the coming 12-month period from dividend payments.

The distribution yield is a very different animal. It can be grossly distorted and misleading, giving you little to no information about what you can expect in the coming year.

Factors Affecting Distribution Yield

There are a slew of factors that contribute to the ETF’s distribution yield. That said, changes in shares outstanding, securities lending and in the ETF’s investment strategy are three major factors that investors should pay attention to.

1. Changes In Shares Outstanding

During periods of rapid creations (increases in shares outstanding), the dividends collected by the ETF may have to be divvied out to additional shares by the time the ETF distributes those dividends at the end of the quarter, causing somewhat of a “dilutive” effect, thus “decreasing” the yield.

A great example of this concept is the iShares Core High Dividend ETF (HDV | A-65). Several years ago, investors were surprised when they were seeing yields of 2-3 percent, even though HDV’s holdings were yielding between 3-4 percent.

That’s because over a two-year period from HDV’s launch in March 2011, assets piled into the fund, growing the fund at a blistering rate, with total net inflows of $2.4 billion.

Source: ETF.com

Of course, the opposite is true if the ETF goes through rapid redemptions (decreases in shares outstanding). The distribution yield can “jump,” giving investors a false sense of a higher yield.

Important to note is that from a total returns perspective, flows don’t change anything. But if investors only pay attention to the distribution yield, in extreme cases, it can lead to poor investment decisions.

2. Securities Lending

Most ETFs are structured as open-ended funds, adhering to Regulated Investment Company guidelines, and they’re required to distribute at least 90 percent of their income to shareholders. Therefore, ETFs sitting on a pile of securities-lending revenue can show an usually a high distribution yield.

Let’s look at solar ETFs as an example. Dave Nadig wrote about this last year when the Guggenheim Solar ETF (TAN | B-38) was “yielding” 5.6 percent. Yet none of its holdings was paying out dividends. This massive distribution was clearly attributed to securities-lending revenue from solar stocks that fetched a premium to lend out.

Just keep in mind that distributions from securities-lending revenue do not pass as qualified dividends, meaning they’re taxed as ordinary income.

3. Gains In Forward Contracts

Currency-hedged ETFs “short” forward currency contracts to neutralize the “long” currency exposure of the underlying equities.

Even though the ETF does not take a “net short” position in the currency, if the counter-currency depreciates rapidly against the U.S. dollar, those forward contracts realize gains, which may get distributed out.

I’ll use the Deutsche X-trackers MSCI Brazil Hedged Equity ETF (DBBR | D-51) as an example. Currently, DBBR has a distribution yield of 12.03 percent. Yet its portfolio yield is only 4.12 percent.

How did DBBR yield three times the dividends actually paid out by its underlying holdings?

Over the past year, the Brazilian real plunged 12 percent against the dollar, and the gains made from DBBR’s “short” real contracts are what’s baked into this yield.

In fact, if you looked at DBBR’s distribution yield prior to its ex-dividend date on June 27, 2014, the yield would have been 20 percent! (See my previous blog on DBBR to better understand how this was calculated.)

Finally, Brazilian securities yield roughly 4 percent. So, come tax time, don’t expect to get the beneficial “qualified dividends” rate for the majority of DBBR’s previous distributions, which were, again, from currency contract gains.

The Takeaway

As a side note, the 30-day SEC yield, which is required for all bond ETFs, also exists. This yield is calculated by taking the distributions over the past 30 days divided by current NAV and annualized.

However, the 30-day yield was mostly created to provide a standard, uniform way to display yields for fixed-income funds, and paints a more accurate picture for bond funds that pay out steady, monthly income distributions.

I personally like to look at an ETF’s portfolio yield, as it gives me a better depiction of the dividends actually paid out by the underlying holdings, as opposed to possible one-off distributions from portfolio strategies that may not materialize in the coming year.

If interest rates continue to stay low, high-yield equity ETFs will likely continue to draw interest. If you’re searching for an ETF based on its yield, make sure you understand the displayed ETF yield and how it’s calculated so you’re not caught off guard by future distributions.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.