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Equity-Dividend Funds Get a Stress Test

Rising rates have sunk dividend-focused funds since May, exposing some rate sensitivity among them.

Dan Culloton, 06/25/2013

Dividend-focused portfolios have gotten a bit of a stress test over the past month or so. Here's a quick look at some of the results.

Yields Ahoy
News that the Federal Reserve could begin tapering its rate-suppressing bond-buying program sent the 10-year Treasury yield up from 1.6% at the start of May to 2.6% on June 21, 2013. That caused dividend-paying stocks, which many investors had turned to for yield, to stumble. Indeed, benchmarks such as the FTSE High Dividend Yield Index and Mergent Dividend Achievers Select Index peaked on May 21, 2013, and subsequently lost 3.5% and 4.4%, respectively, through June 21. That's not much worse than broad stock market proxies like the Russell 3000 and S&P 500 Indexes, which shed 4.3% each (other dividend indexes technically peaked a few days earlier: the Dow Jones U.S. Select Dividend Index, for example, hit its apex on May 17 and has lost 4.4% since then through June 21).

This is a very short time period. Your guess is as good as mine as to whether the dividend-stock--and broad market--sell-off continues. The recent rout, however, did offer long-term dividend fund investors an opportunity to better understand what they own. It was a chance to see how interest-rate sensitive some dividend stock portfolios are and what made them that way. To do this, I took a look at large-cap domestic-stock funds with above-market trailing 12-month yields and/or the words "dividend" or "income" in their names. Morningstar doesn't have a dividend-focused fund category, but this screen isolated 193 distinct funds that either deliver or make an implicit promise of exposure to income-generating equities. 

Known Knowns
Looking at the portfolios and performances of these funds from the May 21 top of the FTSE High Dividend Yield and Mergent Dividend Achievers Select Indexes through June 21 confirmed what most investors with a modicum of experience know, or at least should know: It can be dangerous to chase yield for yield's sake and to get too concentrated in certain sectors.

The typical above-average performer in my screen--those funds in the top two quintiles--lost 3.5% from May 21 to June 21, while the average fund in the bottom two quintiles lost 5.3%. The below-average dividend funds had, on average, a higher trailing 12-month yield (2.40% to 1.97%) and bigger helpings of utilities, telecommunications, and real estate stocks. Each of those sectors is traditionally higher-yielding and suffered stiffer losses than the broad market and most other sectors from May 21 to June 21. The Morningstar utilities, communication services, and real estate indexes lost 7.7%, 4.9%, and a painful 14.0%, respectively, in the period.

(To see the average detail of the typical top-performing dividend fund for the period, click here. To see the average detail for the typical below-average-performing dividend fund, click here.)

Diversified and Domestic
Above-average dividend funds, in contrast, had larger stakes in health care and financials stocks, which fell less than most other sectors--the Morningstar indexes for those areas dropped 2.6% and 2.3%, respectively. The top-performing equity-income funds also were more domestically focused, with 87% of their assets in U.S. stocks versus 82% for the typical fund in the bottom two quintiles. A nearly 2% average stake in Asian stocks, while small, didn't help the latter group.

Surprisingly (to me anyway), yield and sector biases seem to matter more than quality. True, the above-average dividend funds, on average, had a lower debt/capital ratio than the below-average equity-income funds--but their average returns on assets, equity, and invested capital were also lower. The typical fund in both the top and bottom quintiles also invested in stocks with similar competitive positions in their industries. The average economic moat, Morningstar's gauge of the mean competitive advantage of a fund's holdings, was somewhere between narrow and wide for both groups.

Dan Culloton is an associate director of fund analysis for Morningstar and editor of Morningstar's Vanguard Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. Click here for a free issue of the Vanguard Fund Family Report.

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