All those `yield' signs should read `caution' for wary investors

Here's the latest favorite word from the financial hucksters: yield. Banks tout high-yield certificates of deposit; insurance companies push annuities with claims of long-term yield; and the latest buzzword in the mutual fund business is ``enhanced'' yield, used to describe a type of fund that is quickly getting the discrediting it deserves. All of these businesses are figuring that most people don't know the difference between yield and total return, and won't bother to find out.

``The word is definitely being abused,'' says Laura J. Berger, executive director of the No-Load Mutual Fund Association. ``People see a yield figure and think they are going to get that return.''

In some cases, the total return may actually be more than the advertised figure. But in many others, it can be less - far less. Infrequent compounding of interest, sales commissions, early-redemption fees, management charges, and marketing expenses can all erode the expected yield.

``I've seen insurance products that promote an 8 percent yield,'' says Robert Underwood, a financial planner in Birmingham, Ala. ``But after the fees and charges are taken out, the actual return is 4.2 percent.''

Yield is supposed to be defined as the return on investment. But the word has been so misused and abused in recent years that ``total return'' has become the more meaningful term. Nowadays, yield seems to mean the current interest rate, as stated by whoever is paying it: A bank may advertise a 6.75 percent interest rate on one-year certificates of deposit, but after compounding, the effective yield, or total return, is 6.9 percent.

In the mutual fund business, Ms. Berger says, yield is the annual income before any gain or loss in the price per share, while total return includes both yield and changes in price per share calculated over the investment period. So while a mutual fund may advertise a ``current yield'' of 7.4 percent on a tax-free bond fund, if bond prices drop your principal will erode, and your total return at the end of a year could end up far lower than 7.4 percent. A negative total return, in fact, would leave you with a loss.

Investors in bond funds, especially municipal bond funds, got a painful lesson in this rule last spring. In a few weeks in April, bond prices dropped dramatically, and many long-term muni-bond funds lost 6 percent or more of their value. Still, the ads and promotional literature were talking about the high tax-free yields while paying little or no attention to share price and how that would affect the total return.

Changes in insurance policy yields aren't so dramatic, but the difference between the yield the insurance agent talks about when you're considering a universal life policy or an annuity and the total return can also be surprising.

``Fees and commissions tend to cut into your return a great deal,'' says Christopher Croft, a financial planner in Palo Alto, Calif. ``You can give up at least 8 percent on commissions in the first year.'' Other costs that can affect how much money you really get include the cost of the death benefit, early-redemption fees, marketing and advertising costs, and administration.

``The problem is, insurance products are still presented as an alternative to investments,'' Mr. Croft says. ``If you have an insurance need, buy insurance protection. But if there's no insurance need, you're better off focusing on something that's just an investment.''

This year's hot investment has been the new crop of ``enhanced yield'' mutual funds. In part these grew out of last year's changes in the tax law, which gave funds more flexibility to use aggressive hedging and trading strategies. Fund managers now make greater use of futures, options, and short selling. These investments - also known as government-plus funds - primarily buy and sell Treasuries certificates and government-backed mortgage certificates, with a high-yield ``kicker.''

The idea is that by selling covered options (you own the security and sell the corresponding call option or option on a futures contract), you trade away some potential gains for immediate income.

One problem is that while you're giving away the opportunity for gain, you aren't giving up the potential for loss. If the income isn't reinvested, investors are likely to lose principal eventually.

Another problem is that options markets are a ``zero sum'' game. For every fund (and fund investor) that gains money on a futures contract, another one loses money, and while the losers in these funds lose more after all the commissions and trading expenses are taken out, the winners don't win as much as they thought.

These vehicles have been selling because brokers and fund sponsors have been able to show current yields in the 13-to-15 percent range. But some of them had a total return of just 6 percent or less, and even those that managed to maintain a higher total return could see it erode quickly in a volatile bond market.

Fortunately, a few brokerages have either stopped selling these things altogether or don't let their brokers mention them unless a customer specifically asks for them first and fully understands the risks.

How do you protect yourself against yield abuse?

First, don't buy the first investment from the first person who tries to sell it to you. Check the competition and talk to financial experts.

Then ask a lot of questions. How much do all the fees, loads, commissions, administrative costs, and transaction costs add up to? How much do these costs take away from what you'll be earning? In a worst-case situation involving interest rates, stock and bond prices, and expenses, how much money will you actually have when you close out this account or policy in one (or two, or three, or more) years?

That's the difference between yield and total return: Yield is what they're paying today; total return is how much cash you get at the end of the investment.

If you have a question that would make a good subject for this column, send it to Moneywise, The Christian Science Monitor, One Norway St., Boston, MA 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.

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