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How Do Dividend Funds Measure Up?

Morningstar research shows the benefits and shortcomings of dividend strategies

Combine historically low interest rates with a growing number of income-seeking retirees, and it’s no surprise that funds with a dividend focus have grown in popularity over the past decade.

In our report “ Dividend Funds Under the Microscope,” we took a closer look at dividend funds in Morningstar’s database to see how the different groups perform and behave when compared with one another.

Below, explore some of the key findings from our research.

Growth vs. income dividend strategies

For this research, we sorted the dividend-focused funds in Morningstar’s database into three different classifications—dividend growth, dividend growth and income, and dividend income—based on the characteristics of their portfolios.

The table below shows the differences in portfolio characteristics of these three groups. Dividend-income funds typically had higher yields and payout ratios than the other two groups, but their dividends grew at a slower rate. They also tended to have a more pronounced value tilt. On average, their holdings traded at lower price/book ratios than the other groups, and they were less profitable, as measured by return on invested capital.

U.S. Dividend Funds Portfolio Snapshot

At the other end of the spectrum, the table also shows that dividend-growth funds provided lower yields than the dividend-income group, but they focused on companies with stronger fundamentals and dividend-growth rates than the other two. Dividend-growth funds, on average, tended to hold more-profitable companies with a higher fraction of their portfolios dedicated to firms with narrow and wide Morningstar® Economic Moat™ Ratings (an indication of their preference for stocks with durable competitive advantages) than those in the dividend-income and dividend-growth-income groups. Dividend-growth funds had an average of 43.3% wide-moat firms and 43.6% narrow-moat firms.

The dividend-growth-income group strikes a middle ground between the dividend-growth and dividend-income groups.

How dividend strategies perform relative to benchmarks

We benchmarked dividend-growth and dividend-income funds against low-cost options that represent each fund type’s respective style.

The table below shows how the dividend-growth group, on average, performed against Vanguard Dividend Appreciation ETF ( VIG), over the trailing one-, three-, five-, and 10-year periods through December 2018.

Trailing Performance for U.S. Dividend Growth Funds

Similarly, the table below shows the numbers for the dividend-income group relative to Vanguard High Dividend Yield ETF ( VYM).

Trailing Performance for U.S. Dividend Income Funds

These tables illustrate that most funds in both the dividend-growth and dividend-income groups failed to survive and outperform their respective benchmark.

High fees are one possible culprit for the low success rates. The average fund in these two groups charged a fee of about 0.90% or more at the start of each time period examined. By comparison, Vanguard Dividend Appreciation ETF cost 0.28%, while Vanguard High Dividend Yield ETF’s fee was 0.25% when they were launched in 2006.

Considerations for fund selection in dividend strategies

Investors need to look beyond dividend yield and past performance to select good dividend funds. Keeping costs low can be one of the simplest and most effective ways to improve the probability of success, as our research shows that the lowest-fee funds from each group had a better total return, on average, than their more-expensive competitors.

Investors can also select dividend funds that ensure the stocks they hold have the desire and capacity to continue making dividend payments. Our research also demonstrates that dividend funds with a higher average profitability usually outperform those with lower profitability (on average). Accordingly, portfolios with higher average profitability tend to hold stocks with the capacity to continue making dividend payments.

For the full analysis, download “Dividend Funds Under the Microscope.”
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