It has become popular for income-oriented funds to publish their current yield. In fact, it is common among multi-asset income, interest-bearing short-term, and money market funds in the South African collective investment scheme industry. We are not sure why the practice arose, but suspect it originated from investors wanting to get a sense of how the yield would compare to a fixed deposit or other products offered by banks.

Naturally, as the practice became more prevalent, the yield was used by advisers to compare and recommend different funds. By using the quoted yield as the primary decision point, it made it easier to select among a range of seemingly indifferent funds. Unfortunately, we think this practice is flawed.

Not only is it a measure that is calculated and quoted in different ways by different providers, but it is also a point estimate that ignores the impact of ongoing active management and, when looking back, very rarely equals the return that was ultimately generated.

Pitfall 1: Calculation of Fund Yields

As simple as it may seem to say that the calculated yield that is quoted gross of fund fees will be higher than a yield quoted net of fund fees, this is often not understood or is hidden deeply in the disclaimers and missed in a cursory glance. The reality is that there are many ways to calculate the yield on a fund—gross of fees or net being just one—and an overreliance on this one number can therefore result in poor decision-making. In calculating the yield, many providers simply do so according to the ASISA standards, taking only the interest paid by the instruments in the fund over the previous seven trading days and annualising that. Clearly, this calculation would generate a different outcome if the period was extended to 14 days.

Other providers calculate the running yield on all the instruments in the fund and publish the weighted average running yield. Finally, some providers calculate the running yield and then convert it to an annual effective yield. That is, they adjust the yield to give effect to the reinvestment of quarterly coupons over the course of the next 12 months.

An effective yield is by definition higher than a running yield (assuming positive interest rates), and hence the two are not worthy of comparison.

Pitfall 2 – Point in time estimate

What happens if the fund manager changes the underlying holdings or instruments in the fund, selling an instrument with a low yield and buying an instrument with a higher yield? That would render the previous quote outdated. And it also highlights that the current quote is a snapshot based on the current fund. Many things can change, including the fund manager’s active management, or the general level of interest rates in the economy, as determined by the Monetary Policy Committee of the South African Reserve Bank (SARB). This action is likely to impact the yield of a fund going forward. When things change, so does the yield. Comparing the yield on a fund today with another at, say, the beginning of 2022, when interest rates were 2.5% lower, is flawed and hopefully illustrates an obvious but often overlooked pitfall in using yield to compare funds.

Pitfall 3 – Yield does not equal expected return

In a stable interest rate environment, one could be forgiven for thinking that the yield quoted by a fund is the return that you will receive from that fund over the next 12 months. But it is not, and this is not a stable interest rate environment. Yield is the only component of total return; the other is the capital component. Let us take two funds, both quoting an 8% yield today. Fund A holds only floating-rate notes, and Fund B holds a diversified basket of floating and fixed-rate interest instruments, including longer-dated fixed rate bonds.

All else being equal, if market interest rates subsequently rise and push up the yields to maturity of longer dated bonds (known as a parallel shift in the yield curve), then Fund B will likely underperform Fund A and the *% yield quote, as the prices of longer-dated fixed rate bond prices will fall as yields to maturity rise.

The opposite is true as interest rates fall. So, after the yield quote comparison, funds positioned differently will perform differently, with the obvious conclusion that the yield quoted cannot be relied upon to forecast the expected return of a fund. Simple changes in interest rates, fund holdings, or other unforeseen events mean that the yield quoted today is rarely the return enjoyed by the investor over the next 12 months.

Conclusion

We have highlighted the main pitfalls associated with income funds and effective yields. Conducting in-depth research and equalising all factors could help, but you would still need a solid understanding of the fund’s strategy and positioning before getting a true sense of the return potential of the fund.

What to focus on? Check whether the quoted yield is gross or net, a running yield or an effective yield, and ensure the date chosen for the comparison between the two funds is the same. Then ensure you have a good understanding of how the funds are managed before offering advice on the basis of the yields quoted by different funds.