Introduction

Investors may be drawn to ETFs for many reasons, not least of which is the potential for investment income—making ETF yield a subject of much attention. In general, yield is a backward-looking annual percentage used to express an investor’s potential income earned from the investment. But yield can be expressed in multiple ways and its calculation affected by multiple variables. To evaluate ETF yield, it’s important to understand which yield measure is being displayed, how it was calculated, and what may have influenced it.

Which yield is it?

All too often, investors look at an ETF’s displayed yield when making investment decisions, only to be surprised on the next distribution date that the yield has “decreased” due to circumstances unrelated to investment income from the ETF’s underlying security holdings. This may stem from the yield calculation being used or other variables affecting the yield expression.

The first step in analyzing an ETF’s yield is to understand which yield measure is being used and how it was calculated. Although a dozen or more yield measures exist, a couple of the most common are the 30-day SEC yield and the trailing twelve-month (TTM) distribution yield.

The 30-day SEC yield is based on a standardized calculation, while distribution yields (TTM) may be calculated differently depending on the fund issuer or data provider. For example, Schwab Asset Management excludes all capital gains when calculating distribution yield (TTM), but other issuers or data providers may include capital gains in their yield calculation.

The yield most commonly discussed or analyzed is the distribution yield (TTM). Because it can be calculated in different ways, it’s important to read the definition of the yield provided by the fund issuer or data provider.

It’s also important to understand the potential effects of several other variables on an ETF’s displayed yield.

Common yield measures

When evaluating an ETF ’s yield, you’re most likely to find one of these options:

30-day SEC yield: The 30-day SEC yield represents the dividends and interest earned over the preceding 30 day period, annualized, and divided by the net asset value (NAV) per share at the end of the period. The resulting yield calculation shows investors what they would earn in yield over the course of a 12-month period if the fund continued earning at the same rate for the rest of the year.

Distribution yield: The distribution yield sums the trailing 12-month (TTM) income distributions from a fund and divides that figure by the final month’s ending NAV. The distribution yield (TTM) may or may not exclude any capital gains distributed, depending on the issuer or data provider.

Variables to consider

Sometimes, factors beyond investment income may contribute (positively or negatively) to an ETF’s displayed yield. Additional variables to consider include capital gains distributions, securities lending income, changes in shares outstanding, price appreciation/depreciation, and return of capital (ROC).

ETF yield: Variables to consider

Investment income

The first obvious distribution source is investment income generated by an ETF’s underlying holdings. In order to avoid fund level taxation, ETFs must distribute substantially all income annually.

With fixed income ETFs, distribution frequency may vary by fund, but distributions tend to include payments from income earned on the underlying investments. With equity ETFs, distribution frequency may vary by fund, but they tend to include dividend payments collected in the fund from the underlying stock holdings.

Keep in mind that the distribution’s taxable rate may differ depending on the source of the investment income. For example, income distributed to the investor from tax-exempt municipal fixed income and real estate investment trust (REIT) securities held in an ETF may be taxed at different rates compared to dividends distributed from equity securities. And dividends may be taxed as qualified or non-qualified dividends,¹ which can also have different tax rates.

Capital gains distributions

Capital gains distributions may be separately displayed by issuers or data providers, or they may be incorporated into the distribution yield (TTM), depending on the source and calculation method of the issuer or data provider. Determining how an ETF’s distribution yield (TTM) was calculated is essential in understanding the breakdown between investment income and capital gains.

While ETFs are generally more tax-efficient than mutual funds due to the creation/redemption mechanism and the use of authorized participants, they can still distribute capital gains based on a number of factors. What’s more, capital gains generated in an ETF can be considered short-term or long-term gains for tax purposes; as such, they may be taxed at different rates.

Securities lending income

Securities lending can be another source of fund distribution that may cause the distribution yield (TTM) to look higher than expected.

Certain ETFs, especially those that target illiquid, harder-to-access securities, may get additional premiums for lending out their underlying holdings if the fund is engaged in securities lending. These can include small-caps, international securities, and certain theme-based securities, such as alternative energy.

Changes in shares outstanding

Rapid and significant changes in shares outstanding from inflows or outflows can also change the distribution yield (TTM). During periods of rapid ETF creations (increases in shares outstanding), the dividends collected by the ETF from its underlying holdings may need to be divvied out to additional shares by the time the distribution is made at the end of the quarter. This can cause a dilutive effect, thereby decreasing the distribution yield (TTM), even though yields of the underlying securities have not changed and the total returns to ETF shareholders are not impacted.

Similarly, the opposite can be true if the ETF goes through a period of rapid redemptions (decreases in shares outstanding). The distribution yield (TTM) can temporarily look higher than the actual weighted average yield of the underlying securities.

Return of capital

ETFs may distribute ROC distributions. An ROC distribution is a nontaxable distribution made and paid out of an ETF’s NAV. Instead of the distribution being taxed, the shareholder’s cost basis is reduced.

All ETFs may generate ROC distributions, but some of the more common types of ETFs that do are REITs and master limited partnerships. Depending on the ETF issuer, the ROC may or may not be distributed. Therefore, it’s important when looking at an ETF’s yields to understand any ROC distributions that may or may not be incorporated into its distribution yield (TTM). Again, whether the ROC is distributed or reinvested back into the fund, the total returns to ETF shareholders should not be impacted.

Summary

ETFs are a popular vehicle for investors seeking higher yields in their portfolios. Yet the distribution yield (TTM) may be affected by variables other than investment income from a fund’s underlying holdings. Therefore, it’s important to understand what’s behind the displayed distribution yield (TTM) by considering how it was calculated. Beware of selecting an ETF solely based on its past distribution yield (TTM).