Alternatives: The Next Dimension in Asset Allocation

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Income investing has become particularly popular in recent years, as near-zero interest rates have left many starved for attractive yields.

As such, many investors have turned to equity ETFs paying out high dividends for a stable source of income. But looking through past distributions and current yield metrics is not always the most accurate method for evaluating an ETF’s yield. There are several nuances to these products that must be taken into account, including capital gains.

Capital Gains

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The ETF structure helps to minimize tax liabilities, including capital gains. However, a number of ETFs do incur capital gains throughout the year, leading to high distributions to investors. The shareholders (you, the investor) of the ETF are responsible for paying the taxes on those capital gains, just as if you had sold an individual security at any time during the year. Knowing this, ETF issuers make a distribution to all shareholders of a fund that incurred capital gains in order to cover the costs to the individual. Further, it is possible to incur capital gains on an ETF even if you did not sell out of your position [see also 101 ETF Lessons Every Financial Advisor Should Learn].

ETFs often hold a number of securities they can be forced to trade throughout the year. The frequency of these trades depends on the methodology of the fund. For example, if Apple (AAPL) was suddenly no longer considered an S&P 500 stock, all funds tracking that index, like SPY, would be forced to sell the stock and buy in to whatever replaced it. This could incur capital gains for the fund and therefore the individual investor. SPY might, in this example, be forced to send out a distribution at the end of the year to cover the cost of this capital gain to all investors. But many confuse the distribution for a dividend yield when in actuality, the fund may have no yield whatsoever.

What to Watch for

ETF issuers will release a list annually of all funds that incurred capital gains. That list is always the best place to start when deciphering a dividend yield. Another telling sign is the frequency of distributions; all capital gains will appear as a distribution just one time per year, typically in December. Sometimes the distributions can be very minor, like those from the ultra-popular iShares Barclays Aggregate Bond Fund (AGG A) in 2011, which was 33 cents per share, or about 0.3% of assets. Other times, the figures can be staggering.

A prime example comes from the Dreyfus Brazilian Real Fund (BZF A-). The fund payed out a jaw-dropping distribution of roughly 27% in 2011, but all of that was due to capital gains, so the effective dividend on the year was 0%. It is always important to look under the hood of a dividend ETF to ensure that you are actually receiving the payout advertised.

It can also help to compare the various metrics used to measure distributions. For example, BZF has a distribution yield of about 29%, which obviously includes the significant capital gains payment. Other metrics such as the embedded income yield and SEC 30-day yield can provide a much more accurate picture of the distributions that can be expected going forward.

Follow Me On Twitter @JaredCummans

Disclosure: No positions at time of writing.

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