Scoop on Dividend Yields of iShares

Reader David Scarpa asks about the iShares MSCI Germany (EWG Quote). "Every listing I've seen -- including the iShares Web site -- states that the dividend yield on these shares is 13%," he writes. "Is this possible? If so, why?"

The question points to some interesting features of iShares, which are mutual funds that track Morgan Stanley Capital International country indices. The yield on iShares MSCI Germany is in fact 13%, although subtracting capital gains taxes the fund must pay, the actual yield comes out to 11%. Still, that is well above the yield of the other iShares, which are mostly in the 3%-4% range. The only other one that comes close is the iShares MSCI Italy(EWI Quote), which has a 10.4% yield before subtracting capital gains.

Tom Taggart, a spokesman for Barclays Global Investors which offers the iShares, explains:

"The yield referred to is the dividend distribution paid on the fund," he wrote in an email to me regarding this question. "The fund is required to distribute at least 95% of the income realized by the fund at the end of each fiscal year, in this case, Aug. 31. The distribution includes dividend income from securities held and any capital gains (net of losses) incurred by the fund."

In short, some of the companies within the portfolio of the fund pay dividends, some don't, and those dividends are passed on to the shareholders, as are capital gains.

But wait, I know what you are thinking: Since the iShares are passively managed, simply tracking the MSCI index, what are the fund managers doing selling holdings, and incurring capital gains or losses? In fact, the funds often have to buy or sell holdings. They do so if MSCI makes changes to an index, adding or subtracting a company or increasing or decreasing the weighting of a company within that index.

But they also sometimes must pare back a holding because of specific regulatory rules against any one stock representing too great a share of the portfolio. Such was the case with Deutsche Telekom(DT Quote), which this spring had begun to represent too great a portion of the portfolio and was pared back. Hence, the capital gains and the tax on those gains were distributed to the shareholders.

Taggart continues: "The total return to an investor in the fund is the capital appreciation -- positive change in market price of the iShare -- plus any dividends paid. When a capital gain is incurred but unrealized, the fund's value increases. When that security is sold for a gain, that gain is then "realized" and must be distributed to the investor before fiscal year end. At that time, there will be a dividend paid and an offsetting reduction in market value. On the day of the distribution, there is a corresponding drop in market price. In this case the net asset value dropped from $23.05 to around $20.52, but the investor received $2.53 in the distribution. So to calculate a total return for the year, you need to look at both market appreciation and distributions."

Thus, while the share price of the iShares MSCI Germany is down 28% since the beginning of the year, by factoring in the yield, the total return is -18%. In other words, the high yield is a bit of good news, but has only partly helped salvage a pretty dismal year.