Essential factors for selecting high-performing dividend funds

[UNITED STATES] Dividends may be a solution for investors looking for income. Dividends are corporate gains that corporations provide to shareholders in the form of cash or shares.

Dividends may give more possibility for appreciation than other income-paying assets, such as certificates of deposit, bonds, or Treasurys, according to Leanna Devinney, vice president and branch leader at Fidelity assets in Hingham, Massachusetts.

"Dividends can be very attractive because they offer the opportunity for growth and income," Devinney told me.

Dividend investing alternatives include single business stocks and dividend-paying funds such as exchange-traded funds or mutual funds. Devinney added that with individual stocks, it is easy to see the dividend a corporation may give in return for holding a share. Notably, not every company pays dividends.

Dividend-paying funds, such as ETFs or mutual funds, may offer a larger exposure to dividend assets, sometimes at a lesser cost, she explained.

While dividend-paying stocks can offer attractive income potential, investors should be aware of the risks involved. Market volatility can impact stock prices and dividend payouts, especially during economic downturns. Additionally, companies may choose to reduce or eliminate dividends to conserve cash or invest in growth opportunities. Diversification across multiple dividend-paying stocks or funds can help mitigate some of these risks.

There are certain factors to consider for investors who want to invest a portion of their portfolios in dividend-paying strategies to meet their income aspirations.

What type of dividend-paying fund best meets my objectives?

There are two sorts of dividend funds to select from, according to Daniel Sotiroff, Morningstar's senior analyst for passive methods research.

The first category focuses on strategies with high dividend yields. Dividend yield is the ratio of a company's annual payouts to its stock price. According to Sotiroff, high-yield methods aim to generate more income than the market as a whole. Companies with high-yield dividends, such as Coca-Cola Co., have typically been operating for decades.

Alternatively, investors may choose dividend growth strategies, which focus on firms that are predicted to regularly increase their payouts over time. According to Sotiroff, these firms, such as Apple and Microsoft, are very new.

Investors should also consider the tax implications of dividend investing. Qualified dividends are taxed at lower capital gains rates, while non-qualified dividends are taxed as ordinary income. Understanding the tax treatment of different dividend-paying investments can help optimize after-tax returns. It's advisable to consult with a tax professional to determine the most tax-efficient strategy for your individual situation.

To be clear, each of these solutions include trade-offs. "The risks and rewards are a little bit different between the two," she remarked. "They can both be done well; they can both be done poorly."

If you're a younger investor looking to increase your money, a dividend appreciation fund is probably a better fit for you, he added. On the other hand, if you're approaching retirement and want to generate income from your assets, a high-yield dividend ETF or mutual fund is generally a better option. To be sure, some fund strategies combine the objectives of present income and future growth.

When evaluating dividend-paying funds, it's crucial to look beyond just the dividend yield. Factors such as the fund's overall performance, expense ratio, and underlying holdings should also be considered. A fund with a slightly lower yield but better total return potential may be more beneficial in the long run. Additionally, examining the fund's dividend growth history can provide insights into its ability to sustain and potentially increase payouts over time.

How costly is the dividend strategy?

Another significant factor to consider when choosing between dividend-paying systems is the cost.

Morningstar's top-rated dividend fund, the Vanguard High Dividend Yield ETF, is well-diversified, so investors won't have a lot of exposure to a single firm, he added. Furthermore, it is "really cheap," having a low expenditure ratio of six basis points (0.06%). The expense ratio is a measure of how much investors spend each year to own a fund.

That Vanguard fund has traditionally produced a yield of roughly 1% to 1.5% higher than the broader U.S. market, which Sotiroff considers "pretty reasonable."

While investors may not want to add the Vanguard fund to their portfolio, he suggests using it as a benchmark. "If you're taking on a higher yield than the Vanguard ETF, that's a warning sign that you're likely exposed to incrementally more volatility and risk," Sotiroff said.

It's worth noting that dividend-paying stocks and funds can play different roles in an investor's portfolio depending on their financial goals and risk tolerance. For income-focused investors, particularly those in retirement, dividend-paying investments can provide a steady stream of cash flow. However, for those prioritizing long-term growth, reinvesting dividends through a dividend reinvestment plan (DRIP) can harness the power of compounding to potentially enhance total returns over time.

Morningstar recommends the Schwab U.S. Dividend Equity ETF, which has a 0.06% cost ratio and outperforms the market by 1% to 1.5%, according to Sotiroff.

Both Vanguard and Schwab funds follow an index and hence are passively managed. Investors can also choose active funds, in which managers predict whether firms' payouts will be increased or decreased. "Those funds typically will come with a higher expense ratio," Devinney said, "but you're getting professional oversight to those risks."