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The messy business of calculating yield

The hunt for yield may be high in investors’ minds but investing on this basis brings with it a require-ment to know what the yield actually represents, particularly with regard to bond funds.

What makes up a yield and what is taken away from it can sometimes be hard to see but knowing the intricacies of how it is calculated is an important part of selecting suitable funds to meet client needs and tax circumstances.

Underlying investments affect the level of yield in a fund but there are other, often overlooked, factors.

All funds can offset costs – management, auditors, legal, trustee, accounting and registration fees – against the capital or income they generate, so end returns, whether they are capital gain or income distribution, will be decreased accordingly.

The guide as to where these costs are offset depends on whether a fund has an income or capital growth focus. Equity income funds invariably place their expenses against capital to maximise yields but growth funds do not want distributable income and so apply charges to income. However, some funds sit halfway between the two objectives, such as bond funds.

Offsetting expenses against income or capital does not necessarily affect end returns. What investors lose in capital, they make up for with greater income distribution and vice versa.

Charges are always a complex part of fund evaluation, whether it those the investor pays or how the fund itself deals with their own expenses

However, it can affect what portfolio is most appropriate for an individual investor.

For example, say there are two bond funds with identical gross yields and identical portfolios. One offsets charges to capital and the other to income. One is suffers an immediate erosion of capital, boosting its distribution while the other has a lower distribution but is allowing greater capital growth potential.

According to Andrew Thomas, product development director at Legal & General Investments, if both funds are invested via tax wrappers, that difference may be small over time. However, outside of a wrapper it could have a tax implication, depending on a client’s circumstances.

Thomas says: “The client must be fully aware of how the fund is structuring their charges as it can materially affect the pattern of returns.”

He also points to another issue with which bond funds must grapple when it comes to capital and income. Changes to accounting rules a few years ago have had a deep impact on fund distributions, altering how a manager classifies a gain or distributable income on holdings.

For example, a bond is purchased below par at 85p, it has 15 years to run but after two years the value has risen to 95p and is then sold. Thomas explains that, historically, a manager would log that as a capital gain.

But today’s effective yield accounting rules classifies the difference between purchase price and par at maturity as income and it is therefore distributable.

As a result, some of the growth in an individual holding may already have been distributed as income. This has led to a shift in the return characteristics of many bond funds, from capital growth to income.

While that example may seem straightforward, there are other implications. Take a bond bought at 70p with two years to run. The price rises through the two years but falls before it matures.

The consequence for the fund is that it would have paid out an income through the rise – income it is now unlikely to recover. According to Thomas, this produces two losses, the capital fall below purchase price plus the income already distributed.

Whether or not such calculations have a material impact on the end investor, it makes it difficult for investors to understand what they are getting when they look at headline yield figures.

The same can be said in other areas of charges – those investors pay themselves and the impact they have on performance, or at least on the assessment of returns.

In the past, when most funds were unit trusts, performance was quoted on either a bid-to-bid basis or offer to bid. The former includes the charges paid by the fund, excluding initial charges, which the latter includes. Even though more than 90 per cent of open-ended funds now use the Oeic structure and are therefore mid-priced, we still use the expression offer to bid, which can be misleading.

Premier Asset Management managing director of sales and marketing Simon Weldon says few investors now pay the full initial charge.

Instead, funds are provided to platforms at net asset value and, in turn, they levy a charge for adviser remuneration, meaning there is no standard initial charge in any one fund as some advisers may discount or use fees.

Calculating performance on this basis makes a big difference in the analysis of returns.

For instance, over three years to June 1, 2011, 30 portfolios in the UK all companies sector produced a negative return, bid to bid, according to Financial Express data. However, on an offer-to-bid basis, another 27 lost money – or did they?

Some may argue that even though the full initial charge is included, at least all funds are still measured on the same basis, except they are not. Because some groups anticipate they no longer receive an initial charge for themselves, they have lowered their charge to a published level of around 3 per cent to cover potential adviser charging, says Weldon.

At the same time, other groups have retained the full 5 per cent, even though it is never levied. As a result, when funds are compared offer to bid, some may factor in a 3 per cent charge, others the higher 5 per cent spread, giving some portfolios a 2 per cent enhancement over the others.

Charges are always a complex part of fund evaluation, whether it those the investor pays or how the fund itself deals with their own expenses. None of these practices is considered a disadvantage for the end investor. However, without knowing what goes into a headline yield or assessing performance in a clear manner, it makes the job of managing client expectations difficult.



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