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Portfolio Strategy

Reading between the lines: The nitty-gritty on ETF payouts Add to ...

Even the most useful and sensible of investing products can turn out to be more complex than you thought.

Exchange-traded funds that pay monthly income are a good example. Put them on your short list if you need a well-diversified, low-cost way to squeeze income from your investment dollars, but mind the details. Two areas to focus on: yield, and the extent to which a return of capital is present in the monthly payouts.

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Comments I’ve received from investors suggest some people are not getting the yields they expected from their monthly income ETFs. Others have received their 2011 tax documents and found that, in addition to bond interest and dividends, the income they’re receiving in their non-registered accounts includes a significant return of capital. That’s a turnoff to investors who want the simplicity of being paid with interest and dividends only.

Naturally, investors bear some responsibility for understanding what they buy. But the investment industry has obligations as well to disclose in simple terms how their products work. In a recent publication for the broad investment fund industry, the Ontario Securities Commission suggested some firms are falling short.

Following a review of income funds of all types, the commission said it would ask for greater clarity in how yields are calculated and more detail on whether a return of capital is part of the distributions made to investors. ETFs are often praised for providing a higher level of disclosure than other types of investment funds, so there’s some reason to hope for better labelling of monthly income funds. In the meantime, let’s look at some things investors need to know when evaluating these products.

Monthly income ETFs generally hold stocks and bonds, or a basket of other ETFs that focus on various income-producing sectors. A key point of comparison in choosing a monthly income fund is the yield, which is calculated as the annualized total income payout divided by share price.

Finding a real-world yield for an income ETF can be a challenge. One reader said he had issues with a fund that was described on the website of the company offering it as having a “portfolio yield” of 5.4 per cent. When this investor checked the yield online at Globeinvestor.com, he found the yield was 4.8 per cent.

The lesson here is that portfolio yield refers to the income paid out by the investments in an ETF, before fees. Distribution yield, which you’ll see in online quotes and on some ETF company websites, is more useful because it’s an after-fee number based on the actual income payments made by a fund.

Unfortunately, distribution yield isn’t a perfect number if you’re looking at monthly income funds that happen to hold some bond ETFs. As you’ll know if you read my Portfolio Strategy column from last year (tgam.ca/DLXB), looking at the distribution yield for bond ETFs can give you a distortedly high picture of your yield. The better indicator of what yield to expect from a bond ETF going forward is yield to maturity minus a fund’s management expense ratio. You can find yield to maturity data on ETF company websites.

If you’re evaluating a monthly income fund that holds bond ETFs in its portfolio, it’s worth looking at those bond funds individually to monitor the gap between their distribution yields and their after-fee yields to maturity. The bigger the gap, the more you should mentally discount the distribution yield for your monthly income fund.

Income payments are one variable in calculating yield; the other is price. But what price? Some ETF companies use the market price and some use the net asset value, which can at times can differ from the market price.

This shouldn’t be a major problem with ETFs because the gap between market prices and NAVs is supposed to be inconsequential. Yves Rebetez, a chartered financial analyst and managing director and editor at ETF Insight (etfinsight.ca), said that of the two, he prefers NAV in the yield calculation because it gives a truer picture of the income produced by an ETF’s portfolio.

The presence of a return of capital in ETF monthly income distributions is something investors just have to live with if they want a monthly income ETF. Return of capital refers to cash over and above the taxable income generated by the investments in a fund.

Each return of capital payment has the effect of lowering the cost that you will use at some point in the future to calculate your capital gain (or loss) when you sell your ETF. Given that only 50 per cent of a capital gain is taxable, you might conclude a return of capital is not a bad thing.

Some investors don’t agree. They like the transparency of living off dividends and interest and leaving their capital alone. But after checking a wide variety of income-focused ETFs (including bond, dividend, diversified income and covered call funds), it seems virtually impossible to avoid at least some return of capital component in distributions.

One explanation lies in the fact that ETF firms must occasionally create new units to satisfy investor demand. Investors who own the newly created units expect a full distribution, even if these units haven’t been around long enough to have generated sufficient dividends and interest.

Morningstar ETF analyst John Gabriel said there’s a cash component that goes into the creation of new ETF units to top up the distributions payable. “From an accounting point of view, that cash component isn’t really a dividend paid by the underlying companies,” he wrote in an e-mail. “So that portion of the distribution is classified as a return of capital.”

Mr. Gabriel said the return of capital is reported only on an annual basis. “It’s an accounting matter typically handled at year end after all the dust settles.”

A return of capital also plays a role in income ETFs with level monthly payments designed to give investors a predictable flow of cash. These funds face a challenge in that quarterly dividends and semi-annual bond interest don’t arrive in an orderly way that easily lends itself to a steady monthly payout. By using a return of capital, ETF companies can smooth the payouts.

“If investors want steady income from investing in sectors that don’t pay out a predictable income stream, there will need to be return of capital from time to time,” said Oliver McMahon, head of product for the iShares ETF lineup, said in an e-mail.

Before buying income ETFs for your non-registered accounts, familiarize yourself with the composition of the distributions. All ETF firms have fund profiles on their websites with a tab dedicated to distributions. Check out the 2011 view for the most recent full-year tally and save yourself from a surprise when your 2012 tax slips arrive.

For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (Rob Carrick).

Follow on Twitter: @rcarrick

 
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