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ETF Specialist

Are Dividend Funds Overvalued?

Despite their popularity, the average dividend-focused fund isn’t trading at a premium relative to the broad market.

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It’s easy to understand the surge in demand for dividend-oriented strategies we’ve witnessed in recent years. As baby boomers age, they generally desire less volatility and higher yields. And bonds aren’t providing the levels of income that they used to. The 10-year U.S. Treasury yielded 2.3% as of Nov. 28, 2016. It yielded 4.5% and 6.1% at the end of November 2006 and November 1996, respectively. Fund families have responded to investor demand. Over the trailing 10 years, around 100 funds offering investors exposure to dividend-oriented strategies have been launched, nearly doubling the number of such funds available to investors. But has the increased demand for dividend-oriented strategies driven the valuations for dividend-paying stocks too high?

Dividend-oriented funds come in two main flavors. There are those that prioritize dividend growth and quality over high current yields and those that prioritize high current dividend yields over dividend growth. The latter often come with greater risk. High-yielding stocks pay out a larger portion of their earnings and have less of a cushion to cover their dividend if their business deteriorates compared with their lower-yielding counterparts. Higher yields may also indicate that a business has poor prospects.

Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.