Why you should ignore a fund's yield

-- | 04/08/2020

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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Rajesh Yadav. He is an analyst at Morningstar. Hello.

Rajesh Yadav: Hi, Holly.

Black: So, Rajesh, you've been doing some investigations into income investing and how that yield figure that we all look at to assess how to pick out funds might not be quite what it seems. Can you quickly tell us what that yield is?

Yadav: Yes. So, the yield number, typically yield of the fund, is what an investor would expect—over the next 12 months investor should expect to receive. Let's say if yields—its quoted yield is 4 per cent, over the next period investor should—next 12 months investor should expect to receive that 4 per cent from their underlying investments.

Black: So, effectively, if they invest £100, they expect to get £4 in income?

Yadav: That's correct.

Black: But your research is saying don't look at the yield. What have you found?

Yadav: What we have found is that quite often investors are overly obsessed with this quoted yield number and it doesn't give you a complete picture and for many reasons it doesn't give you a complete picture because quoted yield is vulnerable to many things. For example, one, it's vulnerable to the market movements. For example, what we are seeing today is a direct impact from Covid-19 related pandemic where we see dividend payments have been cancelled or curtailed to quite large extent. We could also see default risk rising up in the bond market which could really hamper the income a manager would receive from their underlying investments.

The other thing can be that these yield numbers are actually vulnerable to measurement issues which are well documented in the past. And also, it doesn't give investors the true feel of overall risk of the fund—underlying fund investments. So, that yield number, we believe, is slightly misleading in that sense.

Black: And one thing I found interesting to consider in your report is how it's actually more about the performance of the fund because even if the fund still pays its 4 per cent income, if the capital performance has been poor and your £100 is only worth £90, you only get 4 per cent of that £90?

Yadav: Yes. I think this is where the investors—the yield number is—one of the assertion is that yield number is misleading is because although the manager has maintained that yield number, it has come at a cost of capital base has been shrunk. Not only the investors have lost 10 per cent in the example, but it also sets a lower base for the next period.

Black: So, this is where it starts to become apparent that we need to look at more than the yield because would it be true to say you could have two funds both with the same yield and what you end up with overall is very different?

Yadav: Yes. And the yield number is important but equally important is the stability of the distribution they actually receive from their holdings, how stable that capital base has been. So, in your example, the Fund A and Fund B—Fund A could have done a bit organic income they have received from their underlying investment without eroding the capital. And the other fund could have maintained that same yield number but could have eaten into the capital because they had maintained—the capital base has shrunk. Or even the case that they have borrowed the income from the future period to the current period by selling upside of their underlying investments. So, yes, the two funds could have maintained the quoted yield but in a different form and in the future, you are going to have a different outcome for investors.

Black: So, overall, what does this mean for income investors? How do I pick an income fund?

Yadav: I think it's important for investors to just not solely focus on yield number but focus on actual amounts of pounds and pence they receive from their underlying holdings and how stable that has been over the period and what are the risks investment manager is taking to get that income.

Black: Rajesh, thank you so much for your time. For Morningstar, I'm Holly Black.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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