5 Fund Picks for Dividend Investors

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Ever since the financial crisis, investors have been in love with dividends. Joining me to discuss some of his favorite dividend-focused funds is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much of being here.

Russ Kinnel: Good to be here.

Benz: Russ, before we get into these specific fund picks, let's talk about the general case for dividend payers--why you might want to make room for them in your portfolio.

Kinnel: I think dividend-paying stocks offer a couple of advantages, the obvious one being income in a world where there isn't much income to be had. But also, there are some nice defensive characteristics. They tend to be kind of dull stocks that are just steady--obviously, things like utilities and others. And generally--not always, but generally--higher-yielding stocks tend to hold up well in a down market.

In the 2000-02 bear market, we saw them hold up beautifully. In the 2008-09 bear market, it was a much more mixed picture because some of those yield payers were financials, which obviously got hit very hard in that market.

Benz: Right. Let's discuss the role of costs in any sort of dividend-focused fund that you might buy. How are the two interconnected? Because I noticed that all of the fund picks that you're going to recommend really do have quite low costs relative to their peer groups.

Kinnel: A fund pays out income after expenses. So, those expenses actually come from its yield, if it has sufficient yield to cover expenses. Comparing two similar portfolios--one has a 1% expense ratio, the other has a 10-basis-point expense ratio--the cheaper one is going to have a yield of 90 basis points more. So, there is a very direct link there.

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Benz: It's not surprising that you've got a lot of Vanguard funds on your list of favorite dividend-focused funds. Let's start with Vanguard Dividend Growth (VDIGX)--the case for this fund and how its dividend-growth strategy is not all that income-centric, because I think sometimes people think "dividend" means it will have a high payout. [But that's not necessarily the case] with this particular fund or any dividend-growth-focused fund.

Kinnel: Right. The basic idea for dividend growth is that you are looking for companies that have a dividend and have the potential to grow that dividend. In order to grow the dividend, it means you have to have a good balance sheet and some growing revenues. So, it takes you away from utilities and into more high-quality companies with good balance sheets. So, it gives you a little different [mix] of companies. As you say, the yield isn't as great; but on the other hand, the appreciation potential is greater. And we saw in '08 that these funds actually did better than the equity-income-type funds because the balance sheets were so important in '08. These companies held up better in that downturn.

Benz: Let's discuss this particular fund. It is managed by Wellington Management for Vanguard. Let's talk about the management team and the general strategy in play here.

Kinnel: So, Don Kilbride of Wellington runs this fund. They have done just a great job of looking for companies with that dividend-appreciation potential, and you can see the record. It looks great against large-blend funds and against most index funds, including index funds focused on dividend appreciation. So, it's really worked well. And what I love about Vanguard is that their active funds are almost as cheap as their index funds. So, again, you are getting what dividends there are in this strategy to flow through because expenses are about 31 basis points, which is incredibly cheap. So, it is a really good value.

Benz: Vanguard also has, though, an index fund that uses kind of a similar strategy. Let's talk about that one--that's Vanguard Dividend Appreciation (VDAIX). People can buy the traditional mutual fund. They can also buy an exchange-traded fund version. Let's talk about that general approach with the fund.

Kinnel: That's right. So, you are going to save some money versus the actively managed fund. You will save about 10 or 15 basis points; it's not a huge amount, but it's still cheaper. It gives you a little better potential yield. So, the new class of index funds that I really am drawn to are ones like this where there is a logic behind it. It's not too niche-y; it's still a broad-market focus, but it's focused on companies with dividend-appreciation potential--and again, a lot of those are things you can divine from the financial statements. So, it can be a basic rules-based index fund. And again, you have low costs and it really raises the bar, I think, on all dividend-growth funds, both active and passive.

Benz: Another fund that you like--before we leave the dividend-growth strategies--is T. Rowe Price Dividend Growth Fund (PRDGX). Let's talk about it. I assume it has a pretty similar strategy to the ones that we've just talked about.

Kinnel: That's right. It's maybe even a little less income-focused than the two Vanguard funds, but it's still looking for income and appreciation. So, in a way, it's almost like the old-school growth-and-income funds. But again, it has done a really nice job. Tom Huber has been the manager since 2000. So, you have a very experienced manager looking for dividends and appreciation potential. Very much a nice core holding.

Benz: In the past, I know one of our favorite equity-income dividend-focused funds was T. Rowe Price Equity Income Fund (RRFDX). Why isn't that at the top of your list here?

Kinnel: Brian Rogers is stepping down from that fund, and so it loses a bit of its appeal. Also, its performance wasn't quite as good as the other funds that we are going to mention in the equity-income space. It's still a very good fund--a nice, predictable, dependable fund.

Benz: Let's segue away from the dividend-growth strategies into funds that do specifically look to deliver a reasonable payout--that's part of the thesis and play. So, a starting point would be just a good index product like Vanguard High Dividend Yield Index (VHDYX). Let's talk about that.

Kinnel: That's right. This is a fund where the index is skewed toward higher-yielding companies. Obviously, you don't want to skew too heavily because the highest yielders tend to have some big risks involved. But again, this is a really nice way--with very low costs--to tap into yield-paying stocks. I think it's a nice way to get in there. And obviously, it's very predictable and dependable because you know what it's going to buy.

Benz: Then, another fund that has also been pretty predictable, uses a similarly income-focused strategy, that's Vanguard Equity-Income (VEIPX). Let's talk about what's going on there.

Kinnel: That's right. This fund is almost as cheap as its index equivalent from Vanguard. You're only paying a couple of basis points more. So, there's tremendous value coming from this fund. Two thirds of it is run by Wellington's Michael Reckmeyer and then one third by Vanguard's quant group. Vanguard's quant group has actually been steadily, quietly improving the performance they deliver for shareholders. So, the combination is a really nice one. Again, it's not designed to be thrilling. This is a fairly diffuse portfolio that's going to deliver steady income with a moderate amount of risk; but it has actually beaten its index-fund counterpart, and you're only paying 2 basis points more for it. So, certainly, there is potential that it will continue to outperform.

Benz: So, what's the idea with having the quant group run a component of this portfolio? Is the goal to bring down the overall costs of the fund or to improve returns? What are the main objectives?

Kinnel: Right. So, it does bring down the costs. [Second,] they tend to use the quant group to diversify the portfolio a little more, so it will reduce some of the individual-stock risk, some of the sector risk probably, too. So, it does that. And then, third, it also gives them a little more flexibility on capacity. So, if a lot of money comes in, maybe they can give a little more of that to the quant group. So, there are a few factors involved in using them. And as I said, I think, over time, they have gradually improved the quality of their efforts.

Benz: Russ, there's such an appetite for dividend-paying stocks. Thanks for being here to share these really evergreen, core ideas.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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