Stock Funds That Offer Decent Yields at a Low Price

Ultralow interest rates, and plans by the Federal Reserve to keep them that way until at least mid-2015, continue to drive income-starved investors into dividend payers, whose yields have looked competitive next to bonds' skimpy payouts. In fact, through the first nine months of this year, traditional mutual funds focused on equity income had added $17.3 billion in assets despite an overall trend away from equities that has seen investors pull nearly $83 billion out of domestic-stock funds during the same time period.

Stocks' topsy-turvy performance in recent years hasn't hurt the attraction of equity income either. In the wake of the 2008 financial crisis and its turbulent aftermath, investors have come to value dividends, which imply stability and financial strength, more highly. Tread cautiously before dumping bond funds for stock funds, however. Dividend-focused offerings may usually be less volatile than other sorts of stock funds, but tough markets can more than wipe out the small cushion their yields provide against losses. In 2008, for example, the typical equity-income fund sank by 33%. That was better than the broad stock market, to be sure, but still a bruising loss. By contrast, the typical intermediate-term bond fund dropped 5.2%.

Moreover, while dividend payers looked relatively attractive on valuation grounds last year, they don't appear cheap anymore. Exchange-traded funds such as
 iShares High Dividend Equity (HDV) and  SPDR S&P Dividend (SDY) look close to fairly valued, according to Morningstar's equity research. The recent rally also whittled away stocks' yield advantage over bonds. The S&P 500 Index currently yields about 2.3% versus 1.6% for the 10-year U.S. Treasury bond.

All of this is more an argument for keeping your expectations in check rather than fleeing from dividend-oriented investments. With continued low yields in bonds, at least if the Fed continues to get its way, stocks may remain the best game in town. Corporate America also has the wherewithal to boost its payouts thanks to record-high earnings levels.

Most importantly, there's a strong long-term case for dividend payers. Without them, your portfolio could have a tough time keeping up with the market. During the past 80 years, dividends accounted for roughly 45% of the S&P 500's return. Keep in mind, though, that there have been long stretches during which investors downplayed their worth, as in much of the 1990s. And when the market favors more speculative high-growth companies, focusing on dividends won't be as fruitful. For instance,  Vanguard High Dividend Yield Index gained 18% in 2009--not too shabby in absolute terms, but it looked poky next to the broad market, which rose 28% for the year as measured by the Wilshire 5000 Index. To reap the long-term benefits of dividend-paying stocks, you've got to be able stick with them when they don't look as hot.

Also, don't make the mistake of investing on yield alone. Alpine Dynamic Dividend (ADAVX) yields more than 14%, but its aggressive strategy, which involves using leverage as well as betting on fast growers and turnaround plays, has led to steep losses at times--exactly what you don't want from a dividend-focused fund. It dropped 49% in 2008 and another 16% in 2011, all while delivering subpar gains in rallies. Overall, its 8.4% annualized loss for the trailing five years as of Dec. 7 is among the worst in the world-stock category. Investors might like the size of the fund's income payouts, but they've lost a lot of money at times along the way.

Another important consideration for income-oriented investors is the cost of the fund. A fund that yields 2% but charges 1.5% in fees nets investors only 0.5% in income. But a fund with a lower yield--say, 1.3%--but much lower fees--0.3%, for example--produces a take-home payout that's twice as large.

To identify quality funds that pay a decent dividend and charge low fees, we used the Morningstar  Premium Fund Screener tool. We searched all equity funds for those with trailing 12-month yields of at least 2% and expense ratios of 0.75% or less. To ensure the funds had good track records and management, we screened on those with Morningstar Ratings for funds of at least 4 stars and Morningstar Analyst Ratings of Bronze or better. To reduce duplicate share classes of the same fund in our list we applied the distinct portfolio screen. We also left out institutional share classes and those closed to new investors. Both no-load and load funds are included, but Premium Members who prefer only no-load funds can add that as a screen as well as change the dividend and expense ratio limits if they wish. Premium Members can see the full screen  here. The following are two of the funds on the list.

 Vanguard Equity-Income (VEIPX)        
12-Month Yield: 2.75% | Expense Ratio: 0.30% | Load: None       
This offering delivers above-average yields--its payout exceeds those of the S&P 500 and about 90% of large-value funds--while investing in much better-than-average companies. Both Wellington's Michael Reckmeyer, who runs two thirds of the fund's assets, and Vanguard's quantitative equity group seek stocks with yields higher than the S&P 500's, but the sustainability of those payouts is paramount. The managers hold a higher proportion of stocks with economic moats, as designated by Morningstar equity analysts, than most large-value funds. Those advantages usually translate into excess profits, which can be used to support and increase dividends. This fund created fine long-term returns under both Reckmeyer and predecessor Jack Ryan.

 American Funds American Mutual (AMRMX)        
12-Month Yield: 2.35% | Expense Ratio: 0.62% | Load: 5.75%    
The large-value load fund's team of managers seeks to keep its yield above that of the S&P 500 by investing in industry-leading, financially stable companies with sustainable dividends. Nearly all companies in its portfolio have a moat, and the fund's managers are willing to hold cash and bonds if they don't find attractive opportunities. The fund's conservative approach sacrifices gains on the upside but has helped it outperform in bear markets and short sell-offs.

An earlier version of this article appeared April 3, 2012.