Yield to Yield

Income-seeking investors have been in a tough spot lately. Bond, CD, and money market yields are paltry. Pitiful fixed-income yields might make stock dividend yields look attractive by comparison, but they come with extra company-specific and market risk. The 15% tax rate that most stock dividends have enjoyed for the past seven years could expire at the end of the 2010.

However, more companies seem well-situated to reinstate or increase their payouts after using the aftermath of the financial crisis to pay down debt, bolster balance sheets, and amass cash. Some high-quality companies, like  Johnson & Johnson (JNJ), even offer dividend yields higher than the yields on their 10-year corporate bonds. This rare phenomenon makes dividend-paying stocks more appealing to income-seeking investors. So does market volatility, because dividend-paying companies tend to be defensive.

About 60 distinct funds in Morningstar's database use the word "dividend" in their names (many others pursue an equity-income objective), but it's a diverse bunch. Some are dividend funds in name only, while others are dividend zealots that won't own a stock without a payout. Some chase the fattest yields, while others care more about a company's ability to grow its dividend over time. And of course there are a whole bunch of funds in between. The bottom line is that dividend funds don't ensure safety and security, and some introduce even more risk in pursuit of yield.

Dangerously Yieldy
Alpine Dynamic Dividend's (ADVDX) 25% trailing 12-month yield might turn heads, but this odd fund takes some real risks. Its managers follow an aggressive strategy, frequently buying and selling stocks to maximize exposure to dividend payouts and special one-time dividends. All that trading has led to a turnover ratio of 656% and high transaction costs. The fund's brokerage commissions as a percentage of its average assets in 2009 was 1.2%, on top of an already steep expense ratio of 1.18%. There's also the chance that the fund's portfolio could undergo some changes if the favorable dividend tax rate expires at the end of the year as planned. The most recent shareholder letter, in fact, indicates that REITs and international stocks could play a bigger role in the portfolio if that happens. Regardless, the fund's passion for dividends hasn't provided a cushion in down markets; the fund lost nearly 50% in 2008 alone.

Unintended Sector Bets
A dividend-focused fund can be a good way to anchor a portfolio, but it's important to determine how the fund's underlying holdings affect your overall asset allocation. Companies in certain sectors, including telecom, utilities, energy, and financials, have traditionally paid out dividends while others, like technology companies, prefer to reinvest in their businesses. As a result, some high-yielding funds might have excessive exposure to certain sectors.  Thornburg Investment Income Builder (TIBAX), for instance, has about one third of its equity exposure in utility and telecom stocks alone--more than 3 times as much as the S&P 500 Index. Such funds can appear sluggish when their favored sectors are lagging and might look particularly awful at times. Funds that owned a lot of financials leading up to the market crisis, for example, faced a double whammy of the sector's poor performance and corresponding dividend cuts.

What's in a Name?
Then there are the funds that sound like they'd be dividend-centric but simply aren't. They might be required to own a certain percentage of stocks that pay dividends, but the managers' processes might focus more heavily on factors other than yield.  TCW Dividend Focused (TGIGX) falls into that camp. Despite its name, the fund's meager 1.8% trailing 12-month yield lags the S&P 500's. A dividend fund may have a below-average yield if it is more concerned about dividend growth than absolute yield, but those funds tend to gravitate to companies with substantial competitive advantages that make consistent earnings and cash-flow growth more likely (a concept known as economic moat). These companies tend to be defensive in nature and generally held up well during the recent bear market. The weighted average economic moat of this fund's holdings (based on Morningstar equity research) has consistently fallen into the bottom decile of all large-cap funds since the market downturn. That helps explain its 44% loss in 2008, which was worse than the market and many other dividend-focused funds. Investors might have thought they owned a sturdier fund given its name, but that wasn't the case.

Funds That Do It Well
Dividend funds can assume many identities, so it's important to know what you're getting into before buying. Some fund shops and managers have built long, successful track records using dividend-focused strategies. NFJ Investments, which runs  Allianz NFJ Dividend Value (PNEAX) and the closed Analyst Pick  Allianz NFJ Small Cap Value (PCVAX), among others, invests only in dividend-paying companies with low price/earnings ratios. That's kept volatility in check over time without damaging long-term returns. Hersh Cohen, who took his talents to  Legg Mason ClearBridge Equity Income Builder (SOPAX) in 2009 after a successful 31-year tenure at  Legg Mason ClearBridge Appreciation (SHAPX), is another notable dividend investor. Analyst Pick  Vanguard Dividend Growth (VDIGX) is a low-cost option that focuses on financially sound companies with the wherewithal to continue paying and growing their dividends. The fund has one of the highest weighted average moat ratings of all large-cap funds, according to Morningstar equity research, helping it hold up better than the market and most of its competitors during the downturn.  American Funds Washington Mutual (AWSHX) is another pick that targets stocks that have paid out dividends in nine of the past 10 years. As with many dividend-focused funds, it has experienced some rough patches in racier markets, but its steady approach has done well over time.