Dividend-bearing stocks offer several advantages:
Yield: If you get 2% or 3% or more from a stock dividend, you’re starting out with decent cash flow in these low-yield times.
Tax shelter: So-called qualified dividends (the kind paid by most dividend stocks) are taxed no higher than 15% in 2010. Investors with a taxable income of $34,000 or less (or $68,000 for married couples filing jointly) owe no tax at all.
Quality: When you buy a dividend-paying stock, you’re generally purchasing shares of a solid company. “Dividend-paying companies are those that generate excess cash,” confirms Christopher Davis, a senior mutual fund analyst at Morningstar.
Safety: With their cash payouts and history of profitability, dividend stocks tend to do relatively well in bear markets. “Some studies have shown that dividend-paying stocks have significantly outperformed non-dividend payers in down markets going as far back as 1970,” says Tom Lydon, president of Global Trends Investments in Irvine, California, and founder of ETFTrends.com.
A mutual fund or exchange-traded fund (ETF) with portfolios composed of dividend-paying companies can provide all of these advantages without being forced to pick individual stocks. According to Morningstar, there are nearly 100 dividend-focused stocks, mutual funds, and ETFs. To help you choose among them, it’s helpful to know how dividend funds can be sliced and diced.
Mutual funds vs. ETFs. The dividend funds with the longest track records are mutual funds. Typically, of course, they are actively managed, which means a portfolio manager has identified dividend-paying companies that will make good investments. Although there are exceptions, most dividend-focused mutual funds emphasize large domestic companies.
ETFs have gained popularity in recent years because of their low costs, tax efficiency, and transparency. Dividend ETFs generally follow an index of such equities. For example, the largest dividend ETF, iShares Dow Jones Select Dividend Index (DVY), tracks the Dow Jones U.S. Select Dividend Index. Since many dividend ETFs track foreign indexes, they serve as an access point to add foreign dividend payers to your portfolio.
High-payers vs. growers. Dividend mutual funds and ETFs generally split into two groups. One group focuses on stocks with above-average yields. Among the highest-yielding dividend funds, Eaton Vance Tax-Managed Dividend Income Fund (EADIX) currently yields well over 5%. Its top holdings include familiar names such as McDonald’s and ExxonMobil. This mutual fund also holds some high-yielding preferred stocks and may use “dividend capture” strategies, acquiring stocks just before they make their dividend payouts.
Other funds actually have low dividends. That’s because they buy stocks with rising dividends, theorizing that such companies are growing and will amply reward investors in the future. Franklin Rising Dividends (FRDPX), for example, limits its choices to companies that have increased or maintained its dividend rate for the last four consecutive years. Growth companies may trade at relatively high prices, though, which would drive down the dividend yield.
Performance payoff. With so many dividend funds following different strategies, performance varies widely. Nevertheless, dividend funds generally performed well in the last bear market. During 2008’s downturn, the leaders among domestic large-company dividend funds posted smaller-than-average losses and are ahead of the S&P 500 in performance over the last three years.
—Donald Jay Korn