Not all dividend mutual funds are the same. You don’t want to get caught in the trap of thinking investing for income is good enough. The source of the income makes a big difference on your risk and your overall returns. A dividend mutual fund doesn’t just hold high dividend stocks. They may hold traditional blue chip stocks that aren’t the best of dividend yielders, cash, bonds, and real estate investments. You need to learn the differences between different dividend mutual fund types and other investing vehicles that provide similar return profiles.
The Traditional Dividend Mutual Fund
The traditional dividend fund is called the equity income fund. Equity income funds invest in stocks or equities to provide an income source that returns better than your traditional income fund using bonds and cash deposits. These funds often focus on their dividend yield rather than their overall returns.
Originally the investors were looking for monthly or quarterly cash flow to meet their cash needs in retirement. Lately, many investors who are still gathering wealth for their golden years believe that the combination of dividend income and capital appreciation beats true growth stocks because the companies have to maintain good business practices to maintain their dividends and keep their stock investors happy. As their companies grow their dividends increase. As the dividend increases more investors are attracted to the stock until the dividend yield (which is affected by your purchase price) returns to a more market average return. Thus, you get capital appreciation with your income.
The dividend mutual fund will have the highest carrying costs of any of the investment vehicles we’re going to talk about because it is the most actively managed. Researchers, traders, managers and marketers are all on the payroll in an attempt to maximize return and investor appeal. The down side is because these funds are so actively managed and because they are for profit companies, the stocks they choose can sometimes be more for their benefit because it attracts more investment money than it provides actual returns.
The dividend mutual fund can be found in almost all 401ks or large investment house funds. They may be blended into a conservative equity fund.
The Dividend ETF
The dividend exchange traded fund arose with the popularity of everything ETF. Investors love exchange traded funds because they have very low maintenance costs. They have very low maintenance costs because they don’t require any research or decision making. They are simply a basket of stocks that represent a sector or simple filter. All the fund does for you is own all of the different companies and keep them balanced without you having to buy 50 to 500 different stocks, which would be a commission nightmare. There are two main types of dividend ETFs (these classifications exist in the dividend mutual funds as well) achievers and aristocrats._____________________________________
The dividend exchange traded fund or mutual fund that follows stocks because they increase their dividends each year without fail is an achiever fund. The ETFs will usually follow all achiever stocks that have increased their dividends for X number of consecutive years. For example the Vanguard Dividend Appreciation (NYSEArca: VIG), which is technically a dividend mutual fund, but costs more like a ETF because there are hard rules that govern their selection choices, only chooses stocks that have increased dividends for 10 or more consecutive yields with some trading volume requirements. The volume requirements are so they don’t pick up stocks that are too small because mutual funds are very restricted on maximum ownership levels.
Aristocrat Dividend Funds
The aristocrat dividend funds consist of stocks that are the highest yielders within their group that have consistently increased their dividends for 25 years. When you get to the point where you’ve increased your dividend each year for 25 years you pretty much will increase the dividend regardless of your financial situation. I ran into this with Weyerhaeuser in early 2000. The company was struggling in the recession and yet the long term investors were screaming at the thought of not getting the dividend increase (not that it was an aristocrat), but they ended up financing their dividends that year. Not exactly fiscally responsible.
Regardless these funds have great yields like the S&P High Yield Dividend Aristocrats which has averaged 4% yield for the last 5 years. That beats any savings account plus capital appreciation.
Real Estate Investment Trusts
While not exactly a dividend mutual fund (though some dividend mutual funds do own REITs), real estate investment trusts or REITs are a classic income earning investment. Real Estate can be very capitally intense creating a barrier almost too large for small investors to get involved in. The investment trusts can sell shares of the real estate property on the open market giving investors a liquid choice for investing in real estate. These REITs often carry yields as high as 8 to 12% per year. The reason the REITs offer such a high dividend yield is because of special taxation rules. As long as the REIT passes 90% of its cash flow to its shareholders the REIT isn’t taxed on that cash flow. Thus, the REIT doesn’t have the double taxation that the corporation has.
So Just Buy the Highest Yielding Fund?
Just buying the highest yield seems like a gut check good idea. However, many companies with high yields only have them because their stock is very depressed. The company is languishing and it just hasn’t admitted to itself that it will have to cut the dividend. When the dividend is cut the stock will plummet further. If dividend mutual funds hold too many of these stocks you’ll be left with little dividend income or assets.
You need to find funds that choose quality dividend stocks (read: has the cash flow to pay the dividend) and stocks that consistently grow their dividends. This is a power house combination that can give you decades of steady returns. These types of funds work really well with people who use dollar cost averaging to avoid timing the market. You pick up great yields and low prices when the markets are depressed improving your overall returns._____________________________________