Most investors mistakenly equate the “yield” of an investment with its “returns,” leading to confusion about true investment performance. The promise of high yields in covered call ETFs can be hard to resist, especially when double-digit payouts are on the table. However, focusing solely on yield paints an incomplete picture of investment performance. For true portfolio performance, it’s critical to understand the difference between yield and total return and why the latter offers a more complete view of your investment’s success.
Breaking Down Yield vs. Total Return
Yield is like choosing a car based solely on the size of its tires. While big tires might look impressive, they won’t tell you how the car performs overall and in some cases, oversized tires may not fit the car at all. Yield represents the income component of an investment, expressed as a percentage of its initial cost. This income typically comes through dividends, interest payments or option premiums. While attractive—especially in today’s market environment—yield tells only part of the story.
The challenge comes when investors chase high yields without considering the bigger picture. An investment offering impressive income might simultaneously experience declining asset value, potentially eroding overall returns. This is where total return becomes critical. Total return combines both yield and price appreciation (or depreciation), providing a comprehensive measure of investment performance.
For example, a fund may offer a 7% yield, but if its underlying asset price falls by 5%, the total return is just 2%. On the flip side, a fund with a modest 3% yield but strong price appreciation of 5% would provide a more favorable total return of 8%. This clear difference highlights why focusing on total return, rather than yield alone, is essential for building long-term wealth.
The Problem with Focusing Solely on Yield
Investors often struggle between choosing growth and prioritizing income. They want to harness the power of the market but face hurdles with volatility, while traditional dividend strategies often fall short on growth. High yields can seem like an attractive middle ground, but this can come at the cost of excessive risk, high management fees, limited growth potential and poor tax efficiency. Relying solely on yield can create a false sense of security, as a fund with an appealing high yield may lose its shine if the underlying asset value falls.
Imagine two investments, both with a 10% yield over a 10-year period.
Investment 1 provides an 8% total return annually but still yields 10%. Over 10 years, the capital erodes as the asset value declines, leaving $8,171, significantly less than the initial investment. High-yield strategies like this, which distribute part of the original capital, lead to a reduction in the share price instead of growing over time.
Investment 2 also yields 10% but generates a 12% total return annually due to strong asset appreciation. Over the same period, this strategy grows the initial investment to $12,190, a significant capital increase. This comparison makes it clear–yield alone isn’t enough. To build wealth over time, focusing on total return and the sustainability of capital is key.
Disclaimer: The performance examples provided are hypothetical and for illustrative purposes only. They do not reflect actual results and are not a guarantee of future performance.
Why Total Return Matters
Total return, which accounts for both income and price appreciations, provides a clearer and more comprehensive view of an investment’s performance. Through this lens, investors can better understand if their portfolio is growing or if high yields are masking the loss of capital value. Balanced strategies that manage to align consistent income with growth potential can offer a more complete solution.
Approaches that use options can capture steady income while providing capital growth as the market moves. This combination helps investors achieve both potentially reliable income now and long-term financial growth over time.
Conclusion
While high yields may look attractive, yield alone doesn’t ensure meaningful total returns. Adding the lens of total returns balances income with price appreciation and delivers a more complete measure of investment performance to help investors make the best decisions to meet their short and long term needs.
Supplemental
How to Calculate
- Calculate the Gain: Multiply the previous year’s ending balance by the rate of return.
- Calculate the Distribution: Multiply the previous year’s ending balance by the distribution rate.
- Calculate the New Balance: Add the gain to the previous balance, then subtract the distribution.
Example Calculation (First Year)
Let’s take Investment 1 with an 8% total return and a 10% distribution rate, starting with a $10,000 balance.
- Calculate the Gain:
Gain = 10,000 × 0.08 = 800 - Calculate the Distribution:
Distribution = 10,000 × 0.10 = 1,000 - Calculate the New Balance:
New Balance = 10,000 + 800 − 1,000 = 9,800
So, the ending balance for the first year is $9,800.
Definitions
Yield – a percentage view of income relative to ETF price, helping gauge return.
Income – the actual dividends or interest earned by the ETF from its assets.
Distribution – the cash paid to investors, which can include both income and capital gains.
