February 10, 2009
That is one way to mislead investors about returns, but there are other tricks of the trade. One of the simplest is to confound yield with return, and to boast of the former without regard to the latter. Only in special circumstances are yield and return are the same thing, and usually they are not. “Yield” is the income thrown off by an investment vehicle, expressed as a percentage of the price of that investment vehicle. For example, if a stock that is priced at $50 pays an annual dividend of $2, then it has a dividend yield of 4% (=$2/$50). And if—and only if—the stock begins and ends the year at that same price of $50, the return on the stock for the year will also have been 4%. But what if the stock’s price began the year at $50 and falls to $40 at the end of the year? In that case, the dividend yield actually went up (because at the end of the year, it takes only $40 rather than $50 to generate the $2 dividend), but the investor in that stock lost a net value of $8, because of the price decline. The stock in this case had a negative return. In short, yield is only one of two components of the total return, and not even necessarily the most important component. Uncle Sam, you can be sure, is never confused about the two components of return. He taxes income and long-term price increases (capital gains) at separate and distinct rates (though, since the Economic Growth and Tax Relief Reconciliation Act of 2001, for stocks these are usually and for the time being the same rate). This means that, if an investment has both yield and a price return, taxes lower your total return when the pre-tax return is positive, and they may also lower your return even when the pre-tax return is negative, because yield by itself is always positive. This is one reason (among several) that an investment manager should be dedicated to achieving good after-tax returns for a taxable portfolio, not pre-tax returns.
Investment managers have not been above taking advantage of investors’ confusion of yield with return. Nearly twenty years ago, a well-known mutual fund company was promoting a government bond fund (normally considered a safe investment) with “enhanced” yield. The only way to enhance the yield, though, was through the execution of a strategy that the manager believed to be “safe,” but which was not. The manager was making a bet on interest rates that turned out to be very wrong. In order to keep the investors happy, the fund continued to pay out its high “yield”, but these payments weren’t yield; they were actually payouts of the principal of the fund. Returns were negative.
Returns can be slippery. They are essential as indicators of past performance and for framing expectations for the future, but they must be interpreted with care. In the end, what matters for your well-being is not the return you realized, but the value of your portfolio.
* Adam Jared Apt, CFA, is a financial advisor and the owner of Peabody River Asset Management, based in Cambridge, MA.
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