Do You Know What Your Dividend-Focused Fund Owns?

George, a retired Chicago-area individual investor, recently called me with a conundrum. He had a big portion of his seven-figure portfolio stashed in money market funds earning bupkis. To get a little more yield, and maybe some appreciation, he wanted to move some money to an equity-income fund. What did I think of Vanguard Equity-Income VEIPX?

I think a lot of the fund, and I told George so. (Earlier this year I gave it a Silver Morningstar Analyst Rating, which is solid). Still, George's call worried me. Did he know dividend-paying stocks aren't money market or bond substitutes; that they could lose money; and that the strong trailing returns of funds like Vanguard Equity Income didn't presage future results? More importantly did he know what he would own?

Getting Technical 
A lot of income-seeking investors find themselves in George's predicament, and not all of them can answer those questions in the affirmative, especially the last one. Indeed, while George seemed to have a handle on the risks he was contemplating taking, he was surprised to learn the fund and other income-oriented stock funds  in recent years have edged into areas that historically haven't been associated with dividends.

For instance, domestic-equity funds with above-S&P 500 yields and records of at least 10 years currently have more money, on average, in technology stocks and less in financials and utilities companies than they did a decade ago. That's a reflection of how dividend-focused managers' opportunity set has changed over the years. It also shows how yield-seeking investors like George can't take the traditional definition of equity-income stocks for granted.

Say "dividend-paying stock" and many investors are likely to think of utilities, telecommunications, consumer goods, and financial companies. That's still true, but more tech stocks to whom dividends were anathema at the turn of the century are distributing cash to investors now. At the end of April 2012, the information technology sector was the second-biggest contributor to the S&P 500 Index's yield after consumer-staples stocks, up from fifth place in 2011 according to S&P indexes. A new dividend from the benchmark's largest holding, Apple AAPL, accounts for much of that move, but several other tech companies in the S&P, such as Oracle ORCL, Cisco Systems CSCO, and Analog Devices ADI, have initiated or increased payouts in recent years.

Meanwhile, many tech stocks have languished since their 2000 peaks, making them fair game for fund managers who prefer dividends and low valuations. Indeed, Vanguard Equity Income's tech helping has gone from the low single digits to nearly 10% in the past 10 years. Other funds that put a priority on dividend growth as well as yield, such as American Funds Investment Company of America AIVSX, Columbia Dividend Income GEQAX, and Legg Mason ClearBridge Equity Income Builder SOPTX, have between 14% and 18% in tech stocks now. Overall, the average U.S. stock fund with an above-market yield and 10-year record keeps 73% more in the tech sector than it did 10 years ago. Meanwhile, its utilities and financials stakes have dropped by 44% and 25%, respectively.

  - source: Morningstar Analysts

What's Risky? 
These changes could alter risk profiles of funds with above-average yields, but perhaps in counterintuitive ways. Over the long term (10 years or more), the Morningstar Technology Index has shown more volatility than most other sectors in terms of beta and standard deviation of returns. The credit bubble bust, however, has made the Morningstar Financial Services Index the most turbulent sector over the one-, three-, and five-year periods. Owning competitively entrenched, cash-rich companies such as IBM IBM, Microsoft MSFT, and Intel INTC rather than banks still recovering from near-death experiences, such as Citigroup C and Bank or America BAC, may prove to be less risky going forward. As J.P. Morgan Chase's JPM recent colossal trading losses show, even purportedly well-run institutions are prone to stumbles and are beset with challenges.

Either way, it behooves yield-hungry investors like George to understand where their yield-oriented stock funds are getting their income from and what risks they carry.