Breaking Down The Different ETF Yield Calculations: TIP, HYG And DEM

Includes: DEM, HYG, TIP
by: Morningstar

By Timothy Strauts

Many people are misleading themselves regarding the actual yield of exchange-traded funds they own. It's not that these folks wish to be disillusioned; they are overwhelmed by the many ways to calculate yield. Unfortunately, the most common calculation method, which involves annualizing the last dividend payment, is the most misleading.

To make better decisions about your portfolio, you should understand the four main yield-calculation methods and when they should be used. And lucky for you, we're here to help. Below, we explain the different calculations and then give some examples of ETFs that could give you misleading information if you rely on only one method.

SEC Yield
Definition: Take all the income that has accrued over the past 30 days and assume this income will continue for the next 12 months. Fund expenses are deducted, and then this annualized income amount is divided by the ETF net asset value at the end of the period.

Advantages: Gives an accurate picture of the current income of the fund. Because the methodology has been standardized by the SEC, it allows fair comparisons between funds. It works very well for most bond funds.

Disadvantages: The calculation is problematic for equity funds. Because most equities only pay dividends on a quarterly basis, the SEC yield will often over- or understate an equity fund's true income depending on the month.

12-Month Yield
Definition: Add up all the distributions over the past 12 months and divide by the current net asset value plus any capital gains distributed over the past year. Capital gains are added back to estimate what the fund's ending price would have been had it not distributed these gains.

Advantages: Gives an indication of the income investors actually received in the fund and not a hypothetical calculation on the future. If a fund has an inconsistent or volatile income stream, the 12-month yield will smooth out the distributions into a more realistic expectation of total income for the next year.

Disadvantages: If interest rates for bond funds rose or fell during the previous year, the income received 11 months ago will be higher or lower than the current portfolio. This will give an inaccurate picture of what investors can expect going forward.

Distribution Yield
Definition: Annualize the last dividend received and divide by the ETF's current net asset value.

Advantages: Reflects the cash distributions the fund is making right now, which may be important to a short-term investor.

Disadvantages: This is the yield calculation that gives the most misleading results. In general, ETFs do not have managed-distribution policies like some mutual funds do; ETFs only distribute the income they receive. Because most individual bonds pay their income on a quarterly or semiannual basis, the income paid out by the ETF on a monthly basis will vary wildly based on the number of bonds in the portfolio that paid an interest payment in the past month.

Average Yield to Maturity
Definition: For an individual bond, it is the annual return an investor would receive if he held the bond to maturity and reinvested all dividends. For an ETF, it is the weighted average of the fund's individual bond holdings' yield to maturities. The calculation does not include fees and expenses.

Advantages: Is the best calculation for determining the long-term-return potential of the portfolio.

Disadvantages: Most ETFs do not hold bonds to maturity, so the fund will never actually receive the return stated. Yield to maturity incorporates expected capital gains or loss into the calculation, so not necessarily all of the stated yield will be received as income.

Now that we have reviewed the different calculation methodologies, let's look at some ETF examples.

iShares Barclays TIPS Bond (NYSEARCA:TIP)
The four calculations give widely different results that can be confusing. Yield calculations for TIPS bonds are problematic because of the way that interest accrues. TIPS have a fixed interest rate and receive adjustments to principle based on the amount of increase or decrease in the Consumer Price Index. For tax purposes, the interest received and increases in principal value are counted as interest income in the year received. The ETF distributes interest and principal increases as income on a monthly basis.

TIP is up more than 15% in the past year, which has lowered its fixed interest rate into negative territory. The negative fixed interest rate can be seen in the SEC yield. In the past few months, CPI has been slightly negative, so there has been no principal adjustment upward. With a negative fixed interest rate and no principal adjustments, TIP has not distributed income since Dec. 1, 2011. Because of this, the distribution yield is 0%. The 12-month yield is still a respectable 3.9% because before December there were regular CPI increases. Because of the unique structure of TIPS bonds, TIP will never pay a consistent monthly dividend, so the best measure of potential yield is the 12-month yield.

iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG)
High-yield bonds are a very volatile asset class, so yields can change very quickly--as seen in 2008 when HYG carried a distribution yield over 13%. You'll notice that HYG's current yields are all relatively close together. The one outlier is the 12-month yield, which is still factoring in the higher distributions that were being paid over six months ago. Investors should expect a yield close to the 6.68% SEC yield and the 6.94% average yield to maturity assuming the NAV doesn't change dramatically in the next few months.

WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM)
Most international companies only pay dividends annually or semiannually. This creates very lumpy dividend payments for DEM. The latest dividend payment in December was small compared with earlier payments in June and September, so the distribution yield is an artificially low 1.75%. The SEC yield is very high, which means that many companies in the ETF have made dividend distributions within the past 30 days. Average yield to maturity only applies to bond funds. For international-stock ETFs with wildly fluctuating quarterly dividend payments, the 12-month yield is the best calculation to use.

Which Is Best
There is no perfect measure of dividend yield. All of the calculations have a use and give the investor information. An analysis should include them all. With an understanding of each calculation's advantages and disadvantages, you should be better able to make wise investing decisions.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.