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Finding the True Champion Dividend-Growth Funds

There is more competition among dividend-growth funds, making it harder to truly stand out.

Dan Culloton, 06/05/2014

This article was published in the May 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

It pays to take a harder look at actively managed dividend-growth funds.

Investors generally like dividends, and who doesn't like growth? Put them together in a stock portfolio or in the name of a fund and they convey stability, quality, sober management, downside protection, and a growing stream of income for retirement.

We grouped funds that invest in companies that pay dividends and have the business models and cash flow that enable them to continue raising them. We found those funds' returns have kept pace with the S&P 500 Index and the average domestic-stock fund from the market's October 2007 pre-financial crisis to the end of March 2014 with less volatility. We aren't the only ones to notice, as dividend-growth funds have attracted nearly $10 billion in net inflows in the past five years through the end of the first quarter of 2014.

Raising the Bar
Not all dividend-growth fund records stand up to increased scrutiny. It's true many funds have been able to set themselves apart from traditional benchmarks such as the Russell 1000 and the Russell 1000 Value indexes by leaning toward stocks that pay sustainable and growing dividends, or at least declaring that they do so. Focusing on such fare has worked well over the long term for several funds in the Morningstar 500. Funds like T. Rowe Price Dividend Growth PRDGX have beaten the Russell 1000 and the S&P 500 by building portfolios with a better mix of dividend yield, valuation, and growth than those bogies. We raised the bar on the whole group by comparing them with dividend-growth indexes and index funds to see whether they add value above and beyond the passive options.

Besides the traditional Russell 1000 and Russell 1000 Value indexes, we measured funds versus the Nasdaq US Dividend Achievers Select Index. The trial screened for distinct large-blend and large-value funds with 12-month yields of less than 150% of the broad U.S. stock market (about 2.5% at the time of the test) that had the words "dividend" or "income" in their names--we threw out some that were more focused on yield, such as  AllianzGI NFJ Dividend Value PNEAX, and added a couple f others whose strategies were more dividend-growth-focused, such as American Funds Washington Mutual AWSHX. It turned up more than 120 funds, about 93 of which had track records long enough for the measuring period.

The comparison examined the absolute and risk-adjusted performance of this group relative to the Nasdaq US Dividend Achievers Select Index from May 2006 to the end of March 2014. That's short in statistical terms but roughly the published life of that index and also a period encompassing a market peak, trough, and recovery. A lot of dividend-focused indexes have been rolled out in recent years to serve as the basis for new exchange-traded funds. We chose Dividend Achievers Select for its simplicity, longevity, and credibility. A fund tracking that benchmark,  Vanguard Dividend Appreciation Index VDAIX--available as an ETF and an open-end fund— also is a favorite of Morningstar's passive strategies analysts for its high-quality portfolio.

Bad News, Good News
The market-cap-weighted benchmark is based on the old Mergent Dividend Achievers list of stocks that have raised their dividends for 10 consecutive years. The index, however, uses some quality screens developed at the behest and with the help of Vanguard that weed out stocks with unsustainable dividends. The screens kicked out Citigroup C, for instance, in 2006--two years before the bank slashed its dividend in the midst of the financial crisis (though it kept American International Group AIG and other financials).

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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