Yield gap is the difference between a mutual fund’s actual return and what it would have earned by holding recently traded stocks. A study found that funds with a large positive yield gap are more likely to have a favorable return in the future. Yield gap information must be disclosed to the public twice a year, and it can be a determining factor when choosing between funds.
A yield gap is the difference between the return actually provided by a mutual fund and how much that fund would have earned if it had simply held the stocks that were most recently traded. Yield gap information must be disclosed to the public at least twice a year, but nearly 50% of mutual funds report this information on a quarterly basis. A study published in The New York Times in January 2006 found that a mutual fund with a large positive return gap is more likely to have a favorable return in the future than one with a large negative return gap.
This study took place over a 20-year period and examined yield gap information from more than 2,500 national equity mutual funds. The results of the yield gap study were not affected by the number of times portfolio information was disclosed. During the study, the researchers created two hypothetical portfolios based on yield gap information. One contained the top 10% funds with the largest year-over-year return gap. The other portfolio contained the worst performing 10% of the yield gap.
From 1985 to 2003, the first portfolio beat the market by an average of 3.8% each year. The other portfolio underperformed by 4.4%. This performance difference is the largest the researchers have found when backtesting different fund selection strategies over a long period of time.
When a mutual fund is compared with its performance gap, it is compared with its unique performance. This is a change from the traditional method of measuring the success of a mutual fund, which was to compare it to an arbitrary market benchmark. With this old-fashioned method, a mutual fund might look better or worse than it actually is, because it can easily be compared against the wrong index.
While the yield gap isn’t the only tool a person should use to determine which funds to include in a portfolio, it certainly should be a consideration. Furthermore, it can be the determining factor when deciding between funds that otherwise appear to be equal in their potential for success.
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