3 Funds With Tantalizing Dividend Yields

Morningstar.com readers love dividend-paying stocks, if your recent emails in response to my article about the role of dividend payers in a portfolio are any guide.

The thrust of that article was about using dividend-paying stocks alongside, rather than in place of, bonds--especially if you're retired or getting close to it--but I'd agree that income-producing stocks have plenty to recommend them. Dividend producers can deliver yields that are on par with or even better than bonds, along with the potential for capital appreciation. The ability to pay a dividend is also an indication of a company's financial strength and quality: Dividend payers have higher financial health grades, per Morningstar, than non-dividend-payers, and they're also more likely to have moats. Finally, dividend-paying stocks are arguably cheaper than the broad equity universe right now. That's because slower-growing companies in old-line industries are more likely to pay sizable dividends than fast-growing ones, and the former have dramatically underperformed the latter over the past five years.

There are a two key types of dividend-paying companies, which Morningstar director of global exchange-traded fund research Ben Johnson has helpfully called "growers" and "yielders." In turn, you can sort funds based on which types of companies they tend to emphasize. Growers have shown a tendency to increase their dividends over the years, which helps them deliver a pleasing balance between growing their businesses and paying income to shareholders. But such companies' yields aren't high in absolute terms: Prominent funds like Vanguard Dividend Appreciation ETF VIG have yields that are no higher than that of the broad market.

The second subset of companies, the yielders, deliver dividend yields that are high in absolute terms. These are the types of companies that get income-minded retirees licking their chops. The trade-off is growth: Higher-yielding stocks frequently operate in more-mature businesses where paying out profits rather than reinvesting them is the more prudent avenue for shareholders. Such high-yielding stocks have historically clustered in the financials, energy, utilities, and industrials sectors, to name a few.

Yield-focused investors attracted to the second group of companies should go in with their eyes wide open to the potential risk factors. While there's a lot to like about "a bird in the hand," especially this late in a market cycle, some higher-yielding companies operate in economically sensitive sectors that could be vulnerable to an economic slowdown. High-yielding stocks can also be sensitive to the interest-rate cycle: When rates trend up, investors often jettison high-income-producing stocks, especially in sectors like REITs and utilities, for bonds.

Those caveats aside, investors on the hunt for high-yielding mutual funds and ETFs have never had better or cheaper options; low expenses mean that more income flows through to shareholders. Here are some of Morningstar's most highly rated U.S. equity funds that sport trailing 12-month yields of 2.75% or higher. (Note that developed-markets foreign stocks generally boast more impressive yields than U.S. stocks, but investors should be sure to consider such funds in the context of their total portfolios' asset allocations.) Investors can see the complete list of Medalist mutual funds here, and all the Medalist ETFs here.

Schwab U.S. Dividend Equity ETF SCHD

This fund tracks a sensibly constructed index. It focuses on the higher-yielding half of the 2,500 largest U.S. stocks, excluding REITS. To help mitigate some of the risks that can accompany investing in stocks with high dividend yields--notably, sector concentration, value traps, and dividend cuts--the fund focuses on those companies that have consistently paid dividends over the past decade and score well on various profitability measures. Thus, in addition to offering a solid yield, the portfolio owns more stocks with wide Morningstar Economic Moat Ratings than its category rivals and also scores well on various profitability metrics, such as return on invested capital. A low expense ratio ensures that more of its yield flows through to shareholders.

Vanguard Equity-Income VEIRX

The sole active fund on this list, this stalwart is run by two separate management teams plying complementary strategies. A team from Wellington Management, steered by Vanguard Wellesley Income VWIAX manager Michael Reckmeyer, runs about two thirds of the portfolio. Its focus is on finding dividend-paying companies that appear inexpensive relative to their growth prospects. A team from Vanguard runs the remainder of the portfolio, employing a quantitative strategy that factors in yield, valuation, and growth, among other factors. While it's a touch more expensive than index fund and ETF options, its expense ratio is ultralow relative to most other active dividend-focused funds.

Vanguard High Dividend Yield ETF VYM

Big weightings in a handful of high-yielding sectors (financials, utilities, energy stocks) have historically been the Achilles' heel of many dividend-focused funds, but this fund controls for sector overconcentration by weighting the dividend-paying universe (excluding REITs and smaller stocks) by market capitalization. That has the net effect of reducing sector bets that would be in place without the market-cap weighting, and ultralow costs ensure that it delivers one of the most attractive yields in the category. Its Bronze-rated sibling, Vanguard International High Dividend Yield ETF VYMI, takes a similar tack to investing in dividend payers overseas.