You may have to moderate your expectations for dividend payers, but these offerings remain sound long-term options.
Investors didn't need Apple AAPL to tell them dividends are cool. The tech giant recently announced it would give a part of its formidable $100 billion cash pile to shareholders in the form of dividends, but it's a bit late in joining the party. As of February 2012, more than $8 billion had flowed into dividend-oriented mutual funds over the previous year. Investors embraced these offerings while rejecting stock funds overall, which suffered $110 billion in outflows over the period. (Dividend-focused exchange-traded funds garnered even stronger interest, with $22 billion in inflows.)
Ultra-low interest rates (and promises from the Federal Reserve to keep them that way until at least late 2014) continue to drive income-starved investors into dividend payers, whose yields have looked competitive next to bonds' skimpy payouts. Stocks' topsy-turvy performance in recent years hasn't hurt either. In the wake of the 2008 financial crisis and its turbulent aftermath, investors have come to value dividends, which imply stability and financial strength, more highly.
Tread cautiously before dumping bond funds for stock funds, though. Dividend-focused offerings may usually be less volatile than other sorts of stock funds, but tough markets can more than wipe out the small cushion their yield provides against losses. In 2008, for example, the typical equity income fund sunk 33%. That was better than the broad stock market, to be sure, but still a bruising loss. By contrast, the typical intermediate-term bond fund dropped 5.2%.
Moreover, while dividend payers looked relatively attractive on valuation grounds a year ago, they don't appear cheap after stocks' recent gains. ETFs such as iShares High Dividend Equity HDV, SPDR S&P Dividend SDY, and Vanguard High Dividend Yield Index VYM look fairly valued, according to Morningstar's equity research. The rally also whittled away stocks' yield advantage over bonds. The S&P 500 Index yielded 1.9% on March 28, versus 2.2% for the 10-year U.S. Treasury bond. (Even so, the ETF yields still look fairly competitive. The SPDR offering's 12-month yield clocks in at 3.1%, for instance, while the Vanguard ETF's stands at 2.8%.)
All of this is more an argument for keeping your expectations in check rather than fleeing from dividend-oriented investments. As I noted last month, fund managers we talk to have stuck with dividend payers despite their popularity. With continued low yields in bonds, at least if the Fed continues to get its way, stocks may remain the best game in town. Corporate America also has the wherewithal to boost its payouts. U.S. earnings may be at record-high levels, but the proportion corporations pay out in dividends stands at near-record lows.
Most importantly, there's a strong long-term case for dividend payers. Without them, your portfolio could have a tough time keeping up with the market: Over the past 80 years, dividends accounted for roughly 45% of the S&P 500's return. Keep in mind, though, that there have been long stretches during which investors downplayed their worth, as in much of the 1990s. And when the market favors companies with weaker fundamentals, focusing on dividends won't be as fruitful. For instance, Vanguard High Dividend Yield Index gained 17% in 2009--not too shabby in absolute terms, but it looked poky next to the broad market, which rose 28% for the year as measured by the Wilshire 5000 Index. To reap the long-term benefits of dividend-paying stocks, you've got to be able stick with them when they don't look as hot.
Don't make the mistake of investing on yield alone. Alpine Dynamic Dividend ADVDX yields nearly 13%, but its aggressive strategy, which involves using leverage as well as betting on fast-growers and turnaround plays, has led to steep losses at times--exactly what you don't want from a dividend-focused fund. It dropped 49% in 2008 and another 16% in 2011, all while delivering subpar gains in rallies. Overall, its 7.5% annualized loss for the trailing five years through March 2012 is among the worst in the large-blend category. Investors may like the size of their income payouts, but they've lost a lot of money at times along the way.
To guide you to sounder income-oriented choices, I've screened our equity universe for equity funds with 12-month yields greater than 2.5% and included those with strong managements, fine long-term records, and moderate costs. I'd note that two otherwise worthy contenders, American Century Equity Income ACIVX and Aston/River Road All Cap Value ARIDX, aren't in the list only because they're closed to new investments.