What to Look for in a Dividend-Focused Fund

Question: I want to add some dividend-paying stocks to my portfolio but am not confident in my stock-picking skills. If I opt for a mutual fund or exchange-traded fund, what are the key things to look for?

Answer: Dividend-paying stocks are in the spotlight right now--in fact, Morningstar's resident dividend guru, Josh Peters, worries they could be too popular. And while some investors have gravitated to dividend-paying stocks for their relatively robust yields when compared with high-quality bonds, the two asset classes are not interchangeable. Investors in dividend-paying stocks can expect more volatility than investors in high-quality bonds are used to, so if you need stability above all, no stock or stock fund will ever be able to supplant bonds or cash.

Those caveats aside, it's easy to see why dividend payers are getting attention. Stocks of some high-quality companies such as  Johnson & Johnson (JNJ) currently feature higher yields than their bond counterparts, an unusual phenomenon that speaks to incredible shrinking fixed-income yields. And though their risks are greater, dividend-paying stocks also offer more capital-appreciation potential than most bonds do. Given that the economy appears to be stabilizing and interest rates could rise in the years ahead, many investors see dividend-paying stocks as offering an attractive mix of current income, stability, and growth potential.

Opting for a dividend-focused fund may cost you more than investing in individual dividend-paying stocks, particularly if you're a buy-and-hold stock investor and are executing trades through a low-cost brokerage platform. However, buying a dividend-focused fund can enable you to receive a greater diversification benefit than if you picked off stocks individually.

Here are some of the key questions to ask as you survey the dividend-paying fund universe.

Does Its Approach Sync Up With Your Goals?
Funds that focus on dividends vary widely in their approaches. Some buy dividend-paying stocks whose yields are high, either in absolute terms or relative to the broad market or a market index. Others focus less on a company's current dividend yield than on its ability to increase its dividend in the future. Neither approach is necessarily better, and there are decent examples of funds of both types. But the former strategy will appeal more to investors in search of current income, whereas the latter approach is the way to go for investors who seek financially strong companies with future growth potential but who care less about yield.

What Kind of Dividend Does It Have?
The best dividend-paying investments balance income with capital appreciation and good risk controls. But if you are looking to a dividend-focused fund primarily for current income, be sure to check up on its actual dividend payout first. To help home in on funds with decent dividend yields, start by screening for diversified domestic-equity funds with dividend yields that are at least as high as the S&P 500's trailing-12-month yield of roughly 2%.

In addition, focus on those funds that hold most of their assets in stocks because screening the stock-fund universe for high dividend yields alone will turn up some funds that have substantial stakes in bonds and other assets such as convertibles. ( This screen should get you in the right ballpark.) As a final check, scout around for a fund's SEC yield, which provides the most current snapshot of a fund's current income level. Fund company websites are usually good sources for this information; Morningstar's fund Analyst Reports feature a fund's yield during the past 12 months.

Does Its Cost Structure Add Up?
Costs are always a key consideration when shopping for a mutual fund or ETF, but they're even more important if your objective is take-home yield. That's because a fund's expense ratio is deducted directly from its yield. And with dividend payouts for the broad stock market now below 2% and the average domestic-stock fund's expense ratio more than 1%, it's easy to see how the math can get very ugly very fast for investors in high-cost dividend-focused funds.

The expense ratio could eat up every bit of a fund's yield, or the manager might decide to gun for higher-yielding (and often higher-risk) stocks to offset the fund's built-in expense disadvantage. I usually say that 1% is a reasonable expense cutoff for stock mutual funds, but I'd set the bar even lower for dividend-focused funds--ideally 0.75% or less. Several dividend-focused index funds and ETFs, such as  Vanguard Dividend Appreciation (VIG), are compelling because their costs come in well below this threshold. (Bear in mind that this fund focuses on companies with a history of dividend appreciation; Vanguard Equity Income (VEIPX) is a good example of a cheap offering that focuses on companies with both good long-term potential and solid current yields.)

What Are Its Risk Controls?
Before you invest in a dividend-focused fund, make sure you understand its strategy in the context of yield and risk. Because a fund's dividend yield consists of its dividend per share divided by price, a shrinking share price can jack up a fund's payout. So rather than being a show of financial strength, a very high dividend yield may in fact indicate that a company is in distress. The best dividend-focused funds have safeguards in place to ensure that they're not merely glomming onto the highest-yield securities; Morningstar's fund and ETF Analyst Reports do a good job of summarizing how a fund balances current yield with current risk. Eyeballing a fund's 2008 returns, when many yield-focused funds were stress-tested as a result of weakness in the financials sector, is another way to get your arms around the risk level a dividend-focused investment is likely to entail.  

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