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A few weeks ago, I received an interesting email.
Hello FireCracker & Wanderer,
I’m an investment workshop alumni and longtime blog follower, but I’m struggling to understand yield – specifically, the unpredictability and inconsistency of my actual portfolio yield. As I review your posts at the beginning of each year, inevitably your projected yield from the previous year comes very close to matching your actual yield realized. Clearly, that is reassuring since this is your expense covering income source. I began trying to simulate the same projection process to track my own portfolio yields against expectations. Granted, I am still in the accumulating phase, so I’m still adding new cash, but my actual yield is still fluctuating way more wildly than I would have expected.
Yields do fluctuate from year-to-year for a variety of reasons, and that’s a normal part of investing, so at first, I thought this reader was mistaking those normal year-to-year yield fluctuations as a sign that something was amiss. Until he actually sent me the yield numbers of his actual holdings.
|TRP Growth Stock Fund||$2,861||$8,658||$2,086|
|Institutional Index Fund||$6,266||$13,218||$8,187|
|All Other (VTI, BND, etc.)||$4,519||$5,309||$4,890|
That last row with VTI and BND is more indicative of the “normal” fluctuations that I’m used to seeing, especially with all the weirdness that happened between 2020 and 2022, but what the hell is going on with the other 2? The yield on the TRP Growth Stock Fund spiked by 4x between 2021 and then crashed back down in 2022, to an even lower level than 2020. And this reader’s Institutional Index Fund followed a similar, but not as extreme pattern, doubling between 2021 and 2022, then nearly halving the next year.
Not to mention that stuff like this makes it nearly impossible to reliably use this portfolio to live off of in retirement. Could you live off a job when your paycheck swings so wildly from year to year?
A lot of people send me questions in the vein of “What about this fund XYZ? Is it any good?” And my normal response is “I’m not familiar with that fund, you’ll have to do your own research” since I’m not in the business of reviewing every ETF out there. But these ones made me curious enough to look into it.
As I looked investigated into it, what I found was quite revealing, in that not all funds that advertise high yields are the same. In fact, some can be (intentionally or otherwise) quite misleading. So I thought this would be a an instructive case study in how to troubleshoot yield issues, as well as the criteria I look out for when selecting the funds I invest in.
To be clear, when you are just getting started in investing, or you’re in the accumulation mode of your FIRE journey, investing specifically for yield should not be your main concern. This is because when you’re working, generally your marginal tax rate is quite high. If your investments were throwing off a lot of yield that you don’t actually need, then you’d lose a lot of that yield to taxes. Instead, you want to low-cost index ETFs that generate most of their returns by re-investing their profits and growing their companies. Only when you retire and need that income on a year-to-year basis do you need to care about higher yielding investments.
That being said, when it comes to finding higher yielding investments, it’s not quite as simple as sorting all the ETFs in Google Finance by yield and picking the highest one. That can actually get your some pretty bad results.
Instead, when I look for yield, I like to ask myself three questions, and here they are…
Where Does the Yield Come From?
Not all yield is created equal.
Most people use the term yield and dividend interchangeably, but they’re not the same. What an ETF or mutual fund pays you to hold it is the yield, but how that yield is generated can come from a variety of sources like dividends, interest, rental income, return-on-capital, to list a few.
And the source of that yield may not be immediately obvious from looking at the fund’s main page or even its prospectus, each fund is legally required to tell you how that yield was generated. This is because the tax treatment of each type of yield is different, and so when it comes to tax time, each fund has to disclose this information so the fund holder can properly report it on their tax return.
So this is where you need to look.
Let’s look at the first fund on our reader’s list here. I had never heard of this fund before so I had to look it up. The reader actually sent me that fund’s ticker symbol, but I’ve removed it from this article since, you know, I don’t want to get sued by the company from crapping on their fund, but this is one of those large-cap actively managed equity fund that I wouldn’t touch with a ten foot pole. When I click on the fund’s info page and scroll down to the fund’s distribution schedule, this is what I see.
Right away we can see that this fund pays the vast majority its yield out in a combination of short-term and long-term capital gains. This is typical of actively managed funds, since by definition these funds are built on the premise that the fund manager is super smart and can correctly time the market (Spoiler Alert: They Can’t). That means that over the course of the year, the fund is going to be buying and selling stocks, which are taxable events, and by distributing the profits to the fund holders, that tax burden gets passed onto you as well.
You might be thinking, so what? If the fund manager is making a profit, why is that a bad thing? Well, even if you ignore the statistic that 90% of actively managed funds fail to beat the market after fees are taken into account, this kind of capital-gains driven yield tends to be very uneven.
SeekingAlpha.com has an excellent tool for generating distribution history graphs, and if we pull this fund up on their tool, this is what this fund’s distribution history looks like.
This is why this particular reader was seeing such crazy fluctuations on their distribution history. You want to try living off a fund whose yield looks like that? I sure don’t!
All the funds we use in the Investment Workshop fund their distributions from dividends or interest and not capital gains. These are much more steady and predictable, and less likely to get drastically cut even in times of market distress.
Is the Yield Sustainable?
Another question I get often is about covered call ETFs. Covered call ETFs advertise themselves as an equity fund with high yield, sometimes even above 10%. How do they pull this off, you ask? By using options.
I’m not going to get into the weeds here since I’m not an expert on options, but basically these funds make bets on the stocks in their portfolio about which way the stock’s price is going in the short term, typically in the range of the next few days or weeks. If they’re right, they pocket some extra money, but if they’re wrong, they will forced to sell that stock below market value.
Let’s take a look at one of these covered call ETFs. I’m not going to reveal the ticker symbol, because again, I don’t like lawsuits, but this fund is a high-yield covered call ETF that tracks the NASDAQ. The fund makes its sky-high yield well know, with it’s current eye-popping 13.5% yield featured prominently on its website.
Everything about its yield history looks solid, recording nice predictable income according to SeekingAlpha’s dividend history tool.
So all that seems on the up-and-up.
But remember, you’re only seeing the results of the bets this fund manager gets right. What about when the fund manager gets it wrong?
Fortunately, we can measure this by bringing up a chart of the fund’s price and overlay it on top of the index it claims to track, which is the NASDAQ.
The results look…less than ideal. The NASDAQ is the line in green and our covered call ETF (who shall remain nameless) is *checks notes* sucking hard.
This is an example of a fund where the high yield just isn’t sustainable. This isn’t a case of owning an apple orchard and picking the apples. This is an example of the orchard slowly dying. Eventually this fund will run out of stocks to bet on because it will eventually crash into the ground.
Why Is the Yield So High?
And finally, the last and most important you need to ask when considering whether to add a higher-yielding asset to your portfolio is: Why is the yield so high?
That reason can’t simply be “because the fund manager is smart.” Even if that’s true, what if the manager changes?
I look for reasons that make economical sense to both you and the fund, and that fit with my investment strategy and world outlook. For example, this year I swapped out our bond holdings for the preferred share ETF ZPR, which at the time was paying around 6% yield.
The Canadian Preferred share market is a floating interest rate instrument, meaning that the dividend yield rises with interest rates, similar to how variable-rate mortgages operate. As many home owners are painfully realizing right now, in a rising interest rate environment, variable rate debt is awful to have if you’re a borrower, but on the flip side of that is that’s awesome to have if you’re a lender.
Owning preferred shares right now is similar to being the mortgage lender to those people. They have to pay more because they signed on the dotted line when interest rates were low. Now that interest rate are going up, too bad, so sad. They gotta pay up.
However, I am also aware that if interest rates suddenly drop, these assets are also going to go down. I happen to believe that while interest rates may fluctuate in the short term (the recent bank failures have put this theory to the test), they aren’t going back to pandemic levels anytime soon, so I choose to accept this risk and as long as I’m right, I get to keep collecting those sweet 6% payments.
As you can see, investing for yield is a little more nuanced than simply picking the highest yielding fund. You have to look beyond the numbers and ask yourself some critical questions. Where is this yield coming from? Is this yield sustainable? And what’s the reason behind this yield?
If you can’t answer those questions satisfactorily, then walk away. It’s always better to miss out on an investment rather than plough into something you don’t understand and then get burned by it.
How about you? How do you evaluate whether a high yield investment is worth your attention? Let’s hear it in the comments below!
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8 thoughts on “Dude, Where’s My Yield?”
For clarity, you might want to start the post with basic definitions of yield vs. return.
The funds you considered have high yields but low returns (relative to total stock index funds). Any beginner investor should be able to distinguish that.
The chart for the unnamed covered call ETF that tracks the NASDAQ (QYLD?) likely doesn’t show total return, only the asset price, which is why it looks so bad. Total return is about +5.6% since inception.
That said, high yield fund are a gimmick. They make you feel like you’re getting paid a lot of income, but it’s really just the fund giving you a portion of your own investment back as ROC, plus divs/interest/option premium.
They will also underperform going forward since market upside potential is higher now than a few years ago, so there’s a lot of recency bias with people jumping on the covered call bandwagon.
Something else to watch in ETF’s, I used XDIV as part of my non-registered portfolio. I like the Canadian Dividend Tax treatment. I use the dividends as part of my annual income plan (retired) and it contributed to the “Yield Shield” effect.
As I am filing my taxes much to my disappointment this EFT in 2022 spun off 10% in unrealized Capital Gains. Now I am hoping 2022 is an anomaly and they did more churn in the ETF than normal.
I “tune” my income to produce low taxes, and this cost me an extra Grand in taxes….
Something to watch for if you like to control the Cap Gains you realize, I am still searching for where or how I could predict this for Tax planning as Taxes are my single biggest expense living in the People’s Republic of Kanuskistan.
One other thing to note is most people in today’s higher interest rate market assume their brokerage account money market APY is good for the next month or so, but in fact it changes every 7 days and is more often more volatile than a typical high yield savings account, which is sometimes why the rate seems more attractive.
“…but if they’re wrong, they will forced to sell that stock below market value.”
I’m curious if typical CC funds actually allow in-the-money stocks to sell at option expiration (as opposed to buying back the option and then selling a new call option with new expiration). My guess is that they buy back/re-sell in order for the fund to maintain the stocks that occupy whichever index they’re tracking. Of all the CC funds I’ve looked at, JEPI seems to be the only one that isn’t slowly cannibalizing itself….it does kinda sorta look like the index it’s tracking (S&P500).
Thank you for this post. I’ve always had trouble understanding what was meant by “yield” and your post has furthered my education on this aspect of finance. Thank you to both you and FireCracker for continuing to share your knowledge with with your readers.
If you want to have a financial security life…
You must be useful all the way to the last breath.
Financial Independence is a golden opportunity in freedom to express the most of your contribution.
For a typical 20’s or 30’s something…
A stable, safe and sensible FI walk will take 20 to 30 years time frame.
Anything less meant…
You are checking out the “RAT RACE” too early and that action will have its own consequence!
Very, very, very and very few people have the skill to pick the “TICKER” that funds “EARLY RETIREMENT”.
Great choice! Tower Defense games are always fun. Which Tower Defense game would you like to play?