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Our Favorite Dividend-Growth Funds and ETFs

While their yields aren't especially high, these funds look good from the bottom up.

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Note: This article is part of Morningstar's November 2015 Income Investing Week special report. This article originally appeared July 8, 2015. 

Investors in search of dividend-focused mutual funds will quickly hit a fork in the road. 

In one direction are offerings that aim to deliver a yield that's high in absolute terms. To do so, many such funds emphasize high(er)-yielding sectors like REITs, utilities, and consumer-defensive stocks like tobacco providers. Bank stocks were also a reliable source of above-market yields for years, until many cut their dividends during the financial crisis. 

In the other direction are dividend-focused funds that employ dividend-growth strategies, meaning they focus on companies that have a history of increasing their dividends. Such funds often carry the words "dividend growth" or "dividend appreciation" in their names. For income-focused investors, bypassing dividend-growth funds and ETFs and heading toward those with higher payouts might look like the obvious way to go. Yields on dividend-growth strategies are underwhelming and may even be lower than what you could obtain with a broad-market or S&P 500 index fund. Yields on income-focused equity funds, by contrast, may top 3%. That may not sound like a lot, but the S&P is currently yielding less than 2%. 

But there are a few key reasons to consider a dividend-growth offering instead. One is that companies with the wherewithal to increase their dividends over a period of years--specific requirements vary by fund--generally have sustainable competitive advantages, or what Morningstar calls moats. For example, 70% of the companies in  Vanguard Dividend Appreciation (VIG)(), an index product that focuses on companies with a history of increasing their dividends, have what Morningstar calls wide moats. 

Additionally, the typical company in the fund has an average financial-health grade of A-minus. By contrast,  iShares Select Dividend (DVY), which tracks a benchmark of high-yielding stocks, has less than 30% of its portfolio in wide-moat stocks and an average financial-health grade of B. (S&P 500 index funds fall between the two, with 50% of their portfolios in wide-moat stocks and an average financial-health grade of B-plus.) Highly leveraged, lower-quality companies have generally outperformed during the current market rally, but that may not always be the case. In an equity sell-off, the high-quality companies that are prominent in dividend-growth funds would likely hold up better than higher-yielding but lower-quality firms. In 2008, for example,  Vanguard Dividend Growth (VDIGX) and Vanguard Dividend Appreciation, both of which employ dividend-growth strategies, each lost about 26%, versus a 37% loss for the S&P 500. 

In addition, dividend-growth offerings may be less affected by rising interest rates than would be high-yielding equity funds. The reason is that when bond yields rise, investors often jettison other, more risky sources of yield. Why venture out on the risk spectrum when safer bonds are hitting the market with higher yields attached to them? That helps explain why, as bond yields have risen over the past few months, yield-rich sectors like REITs and utilities have felt the pain. By contrast, yields on dividend growers tend to be more modest; they should be less affected by interest-rate fluctuations because investors weren't really looking to them for current income. 

The catch with dividend-growth stocks, of course, is that they won't tend to do the job for investors in search of current income. Instead, they're best used as part of a total-return strategy, where the investor periodically rebalances to shake off cash flow from the portfolio. (That's the basic strategy in place for my model bucket retirement portfolios, where I've used Vanguard Dividend Growth as the linchpin equity holding.) 

Investors in search of dividend-growth funds can take their pick among index funds, exchange-traded funds, and actively managed offerings. Here are some of Morningstar's favorites. 

 Vanguard Dividend Growth (VDIGX)
Category: Large Blend | Analyst Rating: Gold
It seems that no matter what factors we screen for--whether quality, low costs, or reasonable volatility--this fund makes it through. In keeping with the fund's name, manager Donald Kilbride of Wellington Management looks for reasonably priced companies that can grow their dividends by inflation plus 3%. The end result is a sturdy, high-quality portfolio. The fund has nearly doubled in assets in the past five years, and analyst Alec Lucas points out that it's now the largest single-manager fund in the large-blend category. But he also argues that Kilbride's strategy, which has always featured highly liquid large caps, is well suited to the fund's growing girth. 

 T. Rowe Price Dividend Growth (PRDGX)
Category: Large Blend | Analyst Rating: Silver
While not quite as cheap as the Vanguard offering, this fund has several similar selling points. Manager Tom Huber has been at T. Rowe for 20 years and has run this fund for the past 15; like Kilbride, he favors financially healthy companies. Although the fund's share of wide-moat stocks isn't as large as the Vanguard fund's and it didn't hold up quite as well during the 2008 market downturn, its volatility level, as measured by standard deviation, is comfortably below the S&P 500's over every trailing time period. 

 Hartford Dividend and Growth (IHGIX)
Category: Large Value | Analyst Rating: Bronze
Although its lead manager is different, this Wellington-managed advisor-sold fund is under the umbrella of the same "quality value" team that oversees Vanguard Dividend Growth. That team's head, Ed Bousa, steers this fund while also overseeing the equity component of  Vanguard Wellington (VWELX). It focuses primarily on high-quality large-cap stocks and has exhibited a performance pattern that's similar to the aforementioned funds; it's frequently middling in big market rallies but earns its keep on the downside. 

 Vanguard Dividend Appreciation (VDAIX) /(VIG)
Category: Large Blend | Analyst Rating: Gold
Whereas the previous three offerings are all actively managed, this is an index product that's available either as a traditional index fund or as an exchange-traded fund. It tracks an index of companies that have raised their dividends in each of the past 10 years, a construction method that leaves it heavy on wide-moat firms, which take up more than 70% of the portfolio. The portfolio tends to be heavy on consumer-defensive and industrial names, while downplaying traditionally dividend-rich sectors like utilities and REITs. In part because its expense ratio is lower than any of the funds mentioned here, its yield is also the highest. Analyst Mike Rawson notes that WisdomTree US Dividend Growth (DGRW) and iShares Core Dividend Growth (DGRO), while not as proven, are similarly focused on dividend-growth names.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.