[This article originally appeared in our May issue of the ETF Report.]
When searching for income with ETFs, it may be tempting to simply sort the universe of funds by yield (as you can do with ETF.com’s ETF Screener) and select from among the top hits. While no one should blindly select funds like this, it’s not a bad way to find out what strategies are most effective at generating cash flow. Just remember: Higher yield doesn’t always solve problems; it can create them as well.
Let’s take a look at the current five highest-yielding funds, and dig into what’s generating those big payouts (Figure 1).
Counterintuitively, no fixed-income ETFs make the top five. Instead, the list is dominated by equity funds, and topped by a commodity fund. There are many reasons a fund could land at the top of the yield rankings (not all of them desirable).
Dividend yields are conventionally quoted as the sum of all dividends over the past 12 months, divided by the current price. So if a firm’s price drops precipitously, its yield gets a big boost—at least on paper. Since the price of a stock is determined in part by expectations of future dividends, a falling price implies that future payouts won’t be so big and juicy.
All five top-yielding funds saw falling prices over the last 12 months. Three funds actually had negative returns even after adding back their double-digit yields. It’s likely that quoted yields for these funds will drop going forward—unless prices continue to fall, of course.
ETFs holding income-producing assets receive a steady flow of cash from their underlying securities, but only distribute this cash to investors every so often, typically quarterly. In the meantime, capital flowing in and out of the fund can change the number of shares outstanding. Large outflows just before an ex-dividend date mean that accumulated cash from dividends gets spread among fewer shares, raising yield. Note that this doesn’t affect total return, just yield.
The Yorkville High Income MLP ETF (YMLP) saw almost $30 million in outflows over the past 12 months, or more than 10% of its total assets. The iShares Global Telecom ETF (IXP | B-86) also had outflows for the period.
In February 2014, British telecom firm Vodafone sold its stake in Verizon Wireless and distributed most of the proceeds—some $84 billion—to shareholders. That was enough to push the two international telecom ETFs to the top of the yield rankings. This was a one-time event, though, and we expect both funds to show more down-to-earth yields going forward.
This is an extreme case—Vodafone’s dividend was the largest ever paid, even surpassing Microsoft’s $32 billion special distribution in the fall of 2004—but it serves as a useful reminder. High-yielding ETFs may simply reflect large, one-time payments from their underlying holdings.
Alternative Income Sources
Three of the five-highest-yielding ETFs employ strategies specifically designed to generate income—sometimes at the expense of capital appreciation.