Are you looking for an investment that has the potential to produce a growing income stream and long-term capital appreciation along with reasonable risk? Bond funds won’t suffice; their income is a prisoner of prevailing interest rates, and their capital appreciation in the long term is essentially zero, a combination that is exposed to inflation risk.
REITs (real estate investment trusts) come close, but the dividends from REITs do not receive favorable tax treatment as do the dividends from domestic common stocks.
Convertible bond funds have capital appreciation potential as the stocks underlying the convertibles can appreciate, but the interest stream on convertible bonds does not grow over the long term.
The answer is simple: stock mutual funds and exchange-traded funds (ETFs) with relatively high dividend yields.
These funds specifically focus on investing in companies with high dividend yields—that is, the companies that they invest in pay dividends, and have dividend yields (annual dividends paid divided by share price) that tend to be above the average stock’s dividend yield.
At one time, these funds were classified as equity-income funds or growth & income funds; they have also fallen under the broad classification of value funds.
In today’s environment, mutual funds and ETFs most commonly are classified according to the average market capitalization for the stocks in the portfolio, where a stock’s market capitalization is defined as the number of shares outstanding times the market price per share.
Table 1 provides a sampling of high-dividend-yield common stock mutual funds and ETFs, classified as either large-cap, mid-cap or small-cap value funds. You can see that large-cap value funds and ETFs dominate the list. That comes as no surprise, since larger, more mature firms tend to pay dividends—and more significant dividends than smaller firms in a different growth stage. On average, dividend-paying firms raise their dividends over time. But investing in high-dividend-yield mutual funds and ETFs is not without risk. Dividends are not guaranteed and are at the discretion of the firm. Individual firm dividends can be flat for many years, slashed—or even eliminated.
And in down market cycles, dividend yields can look higher on average simply because stock prices have fallen—with no change in dividends, a lower stock price translates to a higher yield. [See the accompanying box for where to find yield and other data on mutual funds and ETFs.]
The funds in Table 1 were screened to:
The yields for these mutual funds and ETFs in Table 1 are calculated on a 12-month basis. The income over the trailing 12 months is divided by the ending net asset value from last month plus all capital gains distributions, if any, over the last 12 months. Net asset value is the sum of all investments held by the fund at market value divided by the number of mutual fund or ETF shares outstanding. Capital gains distributions are added back because, when a capital gains distribution is made, the net asset value declines by the amount of the distribution and this would overstate yields without the adjustment.
The yields in Table 1 for both mutual funds and ETFs are more than competitive with short-term U.S. Treasury securities and money market funds—above 2.0%, with many in the 3.0% range and some 4.0% and above. In a taxable account, qualified dividend income distributions would be taxed at the dividend/long-term capital gains rate of 15%, a decided advantage over interest that is fully taxable at marginal federal income tax rates. Municipal bond interest, of course, is generally exempt from federal taxation.
The last 12 months’ and year-to-date returns for these funds and ETFs reflect the difficult market conditions that have prevailed lately, but 60% of the three-year average annual returns are positive. The total return figures are just that, however, and include both price change and yield.
Return is only half the equation: For performance, risk is equally important for investment decisions. The total risk column in Table 1 gives important insight into the relative risk of these mutual funds and ETFs.
The total risk index compares all funds and ETFs based upon the variability of return, as measured by the standard deviation of return. The average risk index for all mutual funds and ETFs, including bond funds, foreign funds and sector funds, is 1.00. Funds and ETFs with a risk index below 1.00 are below average in risk. For example, the American Century Equity Income Fund has a total risk index of 0.68—the fund is only 68% as risky as the average fund historically.
At the other extreme is the PowerShares High Yield Dividend Achievers ETF, with a total risk index of 1.44, 44% riskier than the average fund. A look at its portfolio reveals why this ETF is both the yield and risk leader: About 75% of the fund’s investments are concentrated in financial services, primarily banks—a currently beleaguered sector. The three-year total return, at an average of –6.1% per year, is also the worst of the mutual funds and ETFs passing the dividend screen. Consistent dividends can dampen, but not ease, total risk.
Before investing in any fund or ETF, it is always worthwhile to look at the holdings in the portfolio to evaluate industry concentrations or other factors such as the source, in the case of the dividends. [See the accompanying box above for where to find a list of fund and ETF holdings.]
In Table 1, the percentage of the holdings in non-U.S. stocks is given for investors to gauge what portion of the dividends will not qualify for the 15% dividend taxation. Foreign dividends do not qualify for this lower tax preference. The Cullen High Dividend Equity fund has nearly 25% of its holdings in foreign investments, as well as investments in REITs, which also do not qualify for preferential dividend tax treatment.
A growing income stream and potential long-term capital gains along with preferential tax treatment of dividend income, all packaged in a value objective wrapper, can be attractive as one portion of a well-diversified portfolio. And rather than search out individual stocks, mutual funds and ETFs make investing in the package extremely easy.
Just make sure to take the time to understand the strategy and to delve into the holdings of the fund or ETF with a checklist:
|Where to Find Data on Mutual Funds and ETF|
Yield, Return and Risk Statistics: