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A Prisoner of Pricing

The very strategies that aging investors should be deploying today--shorter-maturity bonds and dividend-paying stocks--are precisely the ones the fund industry can't offer efficiently.

Don Phillips, 10/11/2011

This article first appeared in the October/November 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

This should be the golden era of dividend investing. Shellshocked from the financial crisis and nearing retirement, baby boomers have every reason to gravitate toward dividend-oriented strategies. Historically low tax rates on corporate dividends further enhance their appeal, especially in comparison with the current anemic--and much more highly taxed--yields on Treasuries. The combination of competitive yields and reasonable growth prospects should make equity-income and rising-dividend strategies the hottest areas in the investment markets. Yet these strategies and stocks are currently among the market's most neglected. Sadly, the fund industry is at least partly to blame.

The U.S. fund industry wooed investors with two siren songs: first with double-digit yields on bond funds in the 1970s and early 1980s and later with high double- and occasional triple-digit capital gains in the roaring 1990s. Boomers bit, big. Mutual funds became the investment vehicle of choice for a generation immersed in the accumulation period of their retirement planning. The notion that you bought bonds for their high yields and stocks for their growth potential became codified in investors' minds because that was what the fund industry taught them. Sure, there were stocks that paid reasonable yields, but what was 3% or 4% compared with the big gains that stock funds offered during this era? The industry and its key clients bought into a mind-set that simply didn't embrace dividends.

OK. That was then, this is now. Why can't the fund industry that peddled growth to baby boomers during their accumulation years now move to feature dividend income as boomers near retirement? One obstacle is investor greed. Boomers accustomed to big, quick gains haven't exhibited the temperament for slow-growth, dividend-oriented strategies. They are too easily distracted by the latest get-rich-quick scheme. Witness the recent fascination with social-networking stocks. But the bigger obstacle is the fund industry's cost structure. Over the past three decades, funds have systematically shifted much of their distribution cost from upfront or external fees to 12b-1 fees that are embedded in the expense ratio.

This switch was the path of least resistance to overcome objections to front-end loads. By shuffling fees, fund distributors could be paid as much as, if not more than, before without incurring investors' ire. It seemed an ingenious solution, but it came with one major drawback. By shifting more costs into the expense ratio, the industry sabotaged its ability to showcase yield strategies, as higher internal fees eat up much of the yield. (U.S. mutual funds must pay their expenses first out of income, then if necessary, out of capital.) That means that the very strategies that aging investors should be deploying today--shorter-maturity bonds and dividend-paying stocks--are precisely the ones the fund industry can't offer efficiently, and hence is less likely to promote. The industry has become a prisoner of its own pricing.

Ironically, several of the industry's iconic funds built their records by focusing on dividends. John Neff's Windsor Fund benefited from his understanding that dividends were a very significant part of total return yet, despite being the more stable element of returns, were typically discounted in the market by appreciation-obsessed stock buyers. Lesser-known, but similarly brilliant, was Thomas Cameron. His Sovereign Investors fund built a terrific long-term record by focusing on companies with at least 10 years of rising dividends. Funds like these are unlikely to be promoted heavily by shops that depend on B and C share classes for distribution.

Fortunately, several corners of the mutual fund world still offer reasonable yield opportunities. Obviously, low-cost shops like Vanguard can still feature yield strategies without taking undue risks. Similarly, ETF providers like WisdomTree offer low-cost exposure to dividend-oriented strategies. Finally, closed-end funds can offer an appealing way to gain access to dividends. If the funds are bought at suitable discounts, investors can buy a dollar's worth of dividend-earning power for 90 cents. But, on the whole, dividend strategies don't occupy the central position they should for an industry and a generation of investors that both desperately need the stability and more-measured pace of achievement that dividend-oriented strategies provide.

It's time for the industry to rethink the wisdom of internalizing so much of its distribution costs. The policy seemed fine in an era of high capital appreciation, but in a period of reduced expectations and a greater focus on the income needs of investors, it hardly seems the most prudent approach. Why undermine the ability to provide the very thing investors most need?

Don Phillips is Morningstar's president of fund research.

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Don Phillips is a managing director of Morningstar, Inc.

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