Searching for Dividend Yield From Your Stock Mutual Funds
by John Markese
What specifically is yield?
Yield is income, and if income is divided by your investments market value, it can be expressed as a percentage of investment. That is yield. Simple.
Where does one find yield, and what are the risk and tax considerations?
Not so simple.
Yield Plus Growth
Lets simplify this search for yield from mutual funds by making an important cut—consider only sources of yield that have a growth component.
If you seek yield to produce cash flow for spending purposes and not reinvestment, then the income should grow over the long term by greater than the inflation rate to provide a real, inflation-adjusted value.
This growth requirement, however, eliminates fixed-income investments like bond funds. Bond interest doesnt grow. It is fixed for the life of the bond, no matter what the inflation rate, putting in jeopardy the real value of a bond funds yield, although yields on new bonds react to inflation changes over time.
Interest income, taxable as income at the federal level, is also relatively disadvantaged by changes in tax law that expose qualified dividends and long-term capital gains to only a 15% tax rate.
Why not, then, invest in common stock mutual funds whether or not they generate significant yield and withdraw some percentage of the value of the fund investment periodically?
Long-term capital gains and qualified dividends, now taxed at the same rate, should be interchangeable—and on an aftertax basis, they are. But dividends are far more predictable. Just let your mind wander to the experiment with capital values of stocks over the last three years.
Are there any catches to seeking dividend yield?
Yes. Firms that pay dividends tend to be, in general, large-capitalization stocks or special sector investments such as utilities or real estate investment trusts (REITs).
Small- and micro-cap stocks, on average, pay virtually no significant dividends, yet they represent new products and developing industries and should be part of a well-diversified portfolio.
Mutual funds concentrating in utility stocks that do pay above-average dividends offer the investor little in the way of broad portfolio diversification, and they expose an investor to significant industry risk.
The dividends of REITs and of mutual funds that invest in REITs and real estate related companies are high, far higher than the yield on utility and large-cap stocks. But these dividends do not receive the 15% tax rate treatment. They also are susceptible to industry risk, although the rents that generate the dividends grow, on average, at rates exceeding inflation.
High-Dividend Yield Funds
Nonetheless, if yield is your game there are many mutual funds to consider.
In Table 1, the top broadly diversified common stock mutual funds with the highest dividend yields are given; listed separately are mutual funds investing in REITs and real estate industry stocks. Benchmarks For yield comparison purposes, large-cap and small-cap stock index funds are presented. Additional benchmarks include three mutual funds that invest in U.S. government securities and stay within specific maturity-term ranges: short, intermediate and long.
The top-yielding diversified common stock mutual fund is the Vanguard Dividend Growth fund with a yield of 2.7%. Until recently, this fund was a utility sector fund, but now goes after dividend-paying stocks across all sectors. Currently, utility stocks make up less than 4.0% of its portfolio value. Its top holdings include pharmaceutical companies, banks and brokerage firms.
The top-yielding Vanguard fund is the only one of the group to post a five-year annual total return (dividends plus capital gains) loss, 0.5%. However, most of that is attributable to its former life as a utility sector fund.
Every other fund on the list either equaled (one fund) or exceeded the total annual return of the Vanguard 500 S&P index fund over the last five years.
A Look at Risk
Dividends are far more stable than share prices and the total risk index for these funds reflects this stability. The total risk index takes the variability of return for the fund as measured by the standard deviation of returns over the last three years for the fund, and compares that variability to the average for all funds. A total risk index of 1.0 would be average, below 1.0 would be less than average risk and above 1.0 is greater than average risk.
Most of these funds have total risk index numbers below 1.0, and all but two are below the total risk index of the S&P 500 index fund.
In the far right column of Table 1 is the expense ratio of each of these funds—the expense of the fund expressed as a percentage of net asset value. Expenses do not include trading costs or sales loads other than an annual 12b-1 sales charge, if any is levied.
It is important for yield-seeking investors to focus on expenses because expenses eat yield. Dividends are distributed from income net of expenses. Lower expenses translate to higher yields.
It is no accident that the top three yielding diversified common stock funds in Table 1 have some of the lowest expense ratios, and they are also quite low absolutely. The average domestic common stock fund expense ratio hovers around 1.0%.
The Bottom Line
Most of these funds can be found in AAIIs Individual Investors Guide to the Top Mutual Funds; all are included in the Fund Guide Download found in the Mutual Funds Education area and in the Quarterly Low-Load Mutual Fund Update. Yields of other funds and summary yield information for mutual fund categories are reported in these sources.
Keep in mind that mutual fund yields change when dividend growth rates vary and share prices fluctuate. While income in the form of dividends from mutual funds is far more stable than mutual fund values, the only guarantee is that they will change, as will their tax treatment.
John Markese is president of AAII.