Understanding ETF yields
A number of your clients may be looking to generate income from their investment portfolio. As demographics shift, investors have placed greater importance on receiving regular cash flow as a means to supplement retirement.
Exchange traded funds (ETFs) are gaining popularity among income seekers because many ETFs boast attractive yields. However, before you put your clients into one of these income-producing ETFs, there are some key points to consider.
The various forms of ‘yield’
There’s no set standard for what type of yield an ETF publishes, so it’s important to know the distinctions between the various forms of yield out there. To complicate matters, yield terminology is often used interchangeably (and sometimes inaccurately), so regardless of where you get your yield information, be sure to look for any fine print explaining exactly how the yield is being calculated. Below are some useful explanations of widely published yield metrics.
Dividend yield is most commonly shown one of two ways – either as a trailing yield or a forward yield. Both versions measure the cash flow received within an ETF as a percentage of its net asset value (NAV). In the case of a trailing dividend yield, the previous 12 months of dividends are summed up and divided by the most recent NAV. The more popular version though, and the version used by First Asset, is the forward dividend yield (often stated as just dividend yield, but also known as current dividend yield or indicated yield). This version takes the most recently paid dividend amount and assumes that it will remain constant over the coming year. In other words, because dividends are typically paid on a quarterly basis, the most recent dividend is multiplied by 4 and then divided by the most recent NAV. Regardless of the type of dividend yield you’re looking at for an ETF, it will almost always be a gross yield – that is, it has not been adjusted to factor in expenses and taxes payable by the ETF. To get a better gauge on the amount that actually ends up in the investor’s pocket, refer to an ETF’s distribution yield.
Distribution yield is a measure of an ETF’s actual cash flow payments to investors, shown as a percentage of NAV. Typically, distribution yields are based on the sum of all distributions paid to investors over the past 12 months, divided by the ETF’s most recent month end NAV. Because distributions, by definition, are amounts payable to investors, any time you see a published distribution yield, it will almost always be a net yield – that is, it has already been reduced to factor in expenses and taxes payable by the ETF.
An ETF over the past 4 quarters received dividends of $0.07, $0.08, $0.09, and $0.10, respectively, and currently has a NAV of $10.00.
The ETF’s trailing dividend yield would be ($0.07 + $0.08 +$0.09 + $0.10) / $10.00 = 3.4%.
The ETF’s forward dividend yield would be ($0.10 x 4) / $10.00 = 4.0%.
After accounting for expenses and taxes, let’s assume the dividend amounts earned by the ETF were reduced by $0.01 per quarter, thus making the net dividend payouts to investors $0.06, $0.07, $0.08, and $0.09 over the respective quarters (the ETF still trades at $10.00).
The ETF’s distribution yield would be ($0.06 + $0.07 + $0.08 + $0.09) / $10.00 = 3.0%
There are a number of popular ways to calculate yield on bond ETFs. Generally speaking, most ETF providers publish current yield and/or yield to maturity. For investors looking for even more information, coupon rate (%) can often be found as well.
Current yield, much like it’s counterpart for stocks - dividend yield, is a measure of the cash flow (from interest on the bonds) received within an ETF as a percentage of its NAV. It attempts to show how much return the ETF could expect to generate over the course of the coming 12 months from its underlying bond cash flows, assuming current bond prices remain constant. Current yield is more relevant for investors with shorter -term time horizons. The advantage of current yield is that it’s a quick and easy way of understanding cash flows. The disadvantage, however, is that bond prices change constantly, so this is a less accurate measure relative to yield to maturity.
Yield to maturity (YTM), while much more complex in terms of its calculation, provides a far more accurate reading of what an ETF could expect to generate from its underlying bond cash flows if it held all of its underlying bonds until they matured. Because YTM looks out to the maturity of the underlying bonds, this is a more relevant statistic for investors with longer -term time horizons. The most important differentiating factor between YTM and current yield is that time value of money is factored into the YTM calculation. For example, if an ETF held a bond maturing in 10 years, the annual coupon payment of $50 this year, would be worth more than the $50 coupon received in each of the subsequent 9 years. Why? Because $50 today, assuming normal inflationary conditions, would buy you more now than it would in the future.
Coupon rate (%), takes the dollar amount (or coupon) that a bond pays (i.e. $50 every year) and expresses it as a percentage of the face value of the bond. For example, a bond issued with a face value of $1000 that pays a $50 annual coupon, would be said to have a coupon rate of 5%. Generally, ETFs publish weighted average coupon %, which factors in all of coupons of the underlying bonds held and presents it in one clean number.
Covered call option premiums
Covered call ETFs generate income from the dividends earned by their underlying securities and the premiums collected from writing covered call options. While dividends are typically steady and predictable, it’s important to keep the variability of option premiums in mind. Since the premiums collected will vary depending on market conditions and overall volatility, a healthy flow of premiums one month could be much more modest the next month. Furthermore, ETFs can write call options on all of the underlying holdings, a small percentage of the holdings or anywhere in between, which adds to the variability of income according to the ETF’s policy on covered call writing.
It’s important to take a closer look at published yield figures so you fully understand how expressed yields are calculated for each product. It’s also critical that you’re clear on how much yield a particular client requires before selecting a yield-generating ETF, so you can sufficiently meet your client’s needs.
Please contact First Asset for more information about ETFs.
Important information about each First Asset ETF Fund is contained in its respective prospectus. Individuals should seek the advice of professionals, as appropriate, prior to investing. This investment may not be suitable for all investors. Some conditions apply. Copies of the prospectus may be obtained from your investment advisor, First Asset or at www.sedar.com. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.
The commentaries presented are prepared as a general source of information. They are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. The opinions contained in this document are solely those of First Asset and are subject to change without notice. First Asset assumes no responsibility for any losses or damages, whether direct or indirect, which arise from the use of this information and expressly disclaims liability for any errors or omissions in this information. First Asset is under no obligation to update the information contained herein.