Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
As business slackened in the wake of the pandemic, companies in the S&P 500 slashed dividends by nearly $43 billion in the first half of 2020, the most since the global financial crisis of 2008. Counterbalanced by another $15 billion in dividend increases in the first half, it resulted in a net reduction in dividends of $28 billion. The cuts have been widespread, but banking, energy, and travel and leisure were among the hardest-hit sectors.
That action has provided a reminder of the importance of selectivity and diversification when including dividends in a portfolio. While many investors devote great time and attention to selecting individual dividend-payers, one simple way to ensure both diversification and thoughtful portfolio construction is to opt for a good-quality, low-cost mutual fund or exchange-traded fund that invests in dividend-paying stocks.
These funds tend to fall into one of two groups. One group, dividend growth funds, focuses on companies that have increased their dividends over the years. That helps them deliver a pleasing balance between growing their businesses and paying income to shareholders. They've typically held up better in market downturns than their higher-yielding counterparts, but their dividends aren’t high in absolute terms.
The other subgroup, which we can call “yielders” for short, delivers 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 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.
Because yield-rich companies often operate in economically sensitive industries, they’ve been hit particularly hard during the pandemic, and they’ve also been cutting dividends. Even some of the better high-dividend-yield funds lost as much as the S&P 500 during the bear market between late February and late March--about 32%. Since that time, dividend cuts and general weakness in their sectors have inhibited their recoveries relative to the index.
That said, yield-focused funds obviously hold appeal to investors who are on the hunt for income, which is pretty much every retiree today, given how low bond yields have gone. And investors going in with their eyes wide open to the risks of high-yielding equity strategies 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 have a focus on delivering a decent amount of equity income. Investors can see complete list of Medalist mutual funds and ETFs on Morningstar.com.
Schwab U.S. Dividend Equity ETF SCHD Morningstar Category: Large Value Morningstar Analyst Rating: Silver SEC Yield: 4.03% (through 6/30/2020)
This fund tracks a sensibly constructed index, the Dow Jones U.S. Dividend 100 Index. 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. Analyst Venkata Sai Uppaluri notes that it should weather downturns better than its peers. That was the case in the first quarter of 2020, as it lost less than the S&P 500 during the market rout. A low expense ratio ensures that more of its yield flows through to shareholders.
Vanguard Equity-Income VEIRX Morningstar Category: Large Value Morningstar Analyst Rating: Silver SEC Yield: 3.15% (through 6/30/2020)
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’s 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 0.18% expense ratio is ultralow relative to most other active dividend-focused funds.
Vanguard High Dividend Yield ETF VYM/VHYAX Morningstar Category: Large Value Morningstar Analyst Rating: Silver SEC Yield: 3.66% (VYM, as of 6/30/2020)
This has long been one of Morningstar’s top picks among the “yielders,” thanks to its balance of dividends with risk controls. Weighting companies by market capitalization gives the portfolio an emphasis on higher-quality firms while also limiting sector concentration--the Achilles heel of some other dividend-focused strategies. Its ultralow expense ratio--just 0.06% for the ETF--helps it deliver 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.
American Funds American Mutual AMRMX Morningstar Category: Large Value Morningstar Analyst Rating: Gold SEC Yield: N/A
Alec Lucas, a strategist in Morningstar’s manager research group, calls this fund a “tweener.” Its managers focus on dividend-paying industry leaders, like the other funds on this list, though its yield tends to be somewhat lower, in part because of its higher expense ratio. But Lucas points to its cautious strategy as a huge advantage: By losing less in periods of market weakness, its long-term track record has been superb. Like other American Funds, this one features a long-tenured multimanager team and is available with no load or transaction fee via fund supermarket platforms like Schwab’s.