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4 Excellent Dividend-Growth Funds and ETFs

Dividend-growth strategies stand to hold up well on the downside--an important attraction in a not-cheap market.

If you're on the hunt for a dividend-focused fund, there's a lot to like about products that target higher-yielding stocks, plain and simple. I spotlighted some of Morningstar's favorite funds and exchange-traded funds of this ilk in the past. All boast payouts that are comfortably above the broad market's and employ strategies to keep their portfolios clear of huge sector bets and value traps, the bane of many a dividend-focused investor.

While the attractions of these "yielders" are pretty obvious--payouts that top 3% in many cases, plus solid long-term returns--the charms of dividend-growth funds may be a little less readily apparent to the naked eye. The yields on even the best dividend-growth funds and ETFs are barely above the S&P 500's. And over the past decade, the growers' performance has been no better than, and in some cases even worse than, what the S&P 500 and the universe of "yielders" has returned. Vanguard Dividend Appreciation ETF VIG, which targets dividend-growth names, has gained about 13.0% on an annualized basis over the past decade, right in line with the return of Vanguard High Dividend Yield ETF VYM, which boasts a more impressive yield. And both funds have slightly underperformed broad market index trackers, as well as S&P 500 funds, over the past decade because most high-growth technology stocks don't pay sufficient dividends to be included in the dividend-focused funds' indexes.

But the real appeal of dividend growers may be more apparent when the going gets tough--not when it's as easy as the past 10 years have been. That's because firms with a history of dividend growth over a prolonged stretch (many funds target 10 years' worth of dividend hikes) tend to be highly profitable, financially healthy businesses. While dividend growers prioritize delivering cash to their shareholders, they're balancing that against investing in their own businesses. Such firms have often held up better than the broad market, as well as the universe of high-yielding stocks, in periods of economic and market weakness. During the market downturn from early October 2007 through early March 2009, Vanguard Dividend Appreciation dropped 48%, versus a loss of 55% for the broad market and 59% for sibling Vanguard High Dividend Yield Index.

Dividend-growth strategies also look appealing from the standpoint of inflation protection, in that income-focused investors receive a little "raise" when a company increases its dividend. And while rising interest rates are no longer on the front burner, dividend-growth stocks will tend to hold up better in a period of rising bond yields than high-yielding stocks. That's because dividend-growth stocks' yields are more modest to begin with, so they're less vulnerable to being swapped out when higher-yielding bonds come online.

Investors in dividend-growth names can do so in a couple of different ways. One is to buy the individual stocks directly. Doing so requires homework and you may incur trading costs, but you'll avoid management fees and be able to focus on your highest-conviction names. Alternatively, you can go with an actively managed fund or an ETF or traditional index fund focusing on dividend growth stocks. Here's a short list of some of Morningstar analysts' favorites.

This fund hops into the way-back machine to assess the dividend-paying abilities of the companies in its portfolio. The index it tracks, the S&P High Yield Dividend Aristocrats Index, includes stocks from the S&P 1500 Index that have increased their dividends for at least 20 years. Senior analyst Adam McCullough notes that the very long look-back period means the fund misses out on some high-quality, profitable dividend payers that don't have sufficient histories of dividend payments, such as Microsoft MSFT. On the plus side, that screen keeps its portfolio focused on financially stable, shareholder-friendly firms. While the fund lands in the large-value Morningstar Category, it has a much larger allocation to midsize and small firms than does its typical peer; that's because its baseline index is all-cap rather than strictly focused on large stocks. Despite that emphasis, the fund has still held up well in periods of market weakness. The fourth quarter of 2018 was a recent case in point: The fund lost less than 8%, whereas the S&P dropped nearly 14% during that volatile three-month period.

The sole actively managed fund on our list has a lot to recommend it. Manager Tom Huber has been in charge here for nearly a decade, following a consistent approach that focuses on competitively advantaged, shareholder-friendly firms that appear likely to grow or at least maintain their dividends. Analyst Stephen Welch notes that Huber assesses prospective holdings with at least a three-year holding horizon, but his actual holding period has been more than five years, and holdings like Microsoft have been in the portfolio for nearly two decades. Like the best dividend-growth funds, this fund has been a reliable performer on the downside, thanks to its focus on high-quality dividend payers and avoidance of speculative names. As an actively managed fund, it's obviously more expensive than index-focused competitors, but it's inexpensive relative to its category peers.

This passive fund is the largest equity holding in my


, which are geared toward people already in retirement. Like the aforementioned funds, its yield isn't impressive in and of itself, but its focus on companies that have increased their dividends in each of the past 10 years has helped keep a lid on volatility relative to the broad market. Its yield hurdle means that it gives short shrift to certain sectors where dividends are less central, such as technology; that has crimped returns relative to the broad market over the past decade, as fast growth has led the way. But the 10-year period is arguably a bit misleading, in that it entirely omits the last bear market, in which the fund distinguished itself by holding up better than the broad market. Thanks to its low costs and sound strategy, the fund remains a top pick for investors who want to own stocks with a bit less volatility than equities at large.

Vanguard Dividend Growth VDIGX Morningstar Category: Large Blend Morningstar Analyst Rating: Gold SEC Yield: 1.84% 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. This actively managed dividend-growth fund reopened to new investors late last week, after being closed for more than three years. Senior analyst Alec Lucas notes that while the fund is bigger in an absolute sense than when it first closed, all of that growth owes to appreciation in its holdings, not new investor assets. Plus, Kilbride's strategy is built for scale.

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