COLUMN-With dividend funds, the details make all the difference

Mon May 5, 2014 2:27pm EDT

(The opinions expressed here are those of the author, a columnist for Reuters.)

By John Wasik

CHICAGO May 5 (Reuters) - One of the few consistent, although hardly glamorous, strategies in global investing has been companies that routinely raise their dividends.

Although few of these companies will excite your imagination - they are mostly the old-timers of American public companies - they combine steady income and a dollop of growth, allowing you to not only lower risk but also boost your income.

Yet investing in these companies can be difficult because you need to do a lot of homework to gauge whether they will continue to raise their dividends. For many investors, an index fund may make sense.

This is one area where scrutinizing internal fund management can reap higher returns.

I've always liked dividend appreciation exchange-traded and mutual funds because they can track the companies most likely to keep raising their dividends. In a dismally low-yield climate, the combination of growth and income is a welcome respite.

But you have to be aware of the differences among these funds. They are subtle, yet worth noting if you want some flexibility and higher returns.

THE BIG GUNS

The heavyweight in this category of more than 70 funds is Vanguard's Dividend Appreciation Index ETF, which I've recommended in the past. It holds $19 billion in assets.

Vanguard's fund not only tracks companies that have raised their dividends in each of the past 10 years, it drops stocks that might cut their payouts. The fund yields about 2 percent and has gained nearly 16 percent for the 12 months through May 2. It's up 1 percent year-to-date and charges a meager 0.10 percent annually for management expenses.

A worthy competitor is another Vanguard product - the Vanguard Dividend Growth Fund, which is up nearly 17 percent for the past 12 months through May 2 and 2 percent year-to-date. Its yield is just under 2 percent, and it charges 0.31 percent for annual expenses.

While the funds have similar objectives and the growth fund charges three times more for management, the growth fund's returns have been two percentage points higher over the past three years. That's because nearly two-thirds of the growth fund is weighted toward stocks in just four sectors: healthcare, industrials, consumer defensive and consumer cyclical.

What's special about these sectors? They've mostly been in favor as the United States works through its sluggish recovery and market movers remain skittish about the possibility of higher interest rates. The appreciation index fund has nearly half its portfolio's holdings in industrials and consumer defensive stocks.

SPREADING RISK

Placing your bets this way works in some markets but not in others; sectors fall in and out of favor like middle-school friendships. The strategy succeeds only if managers can tweak their portfolios to time undervalued sectors and downplay them once they fall out of favor.

For a more evenly weighted dividend growth approach, consider the FlexShares Quality Dividend ETF, which has no more than 14 percent of its holdings in any one sector. Charging 0.38 percent in expenses, it sports a somewhat higher yield than the Vanguard funds at 2.5 percent. The fund is up 20 percent for the 12 months through May 2 and almost 3 percent year-to-date.

The larger takeaway is that focusing on dividend payers today still makes sense in a slow-growth economy. According to the most recent FactSet Dividend Quarterly Report, the S&P dividend payout ratio - the percentage of companies paying dividends - "remains one of the highest non-recession levels since 2004."

And with traditionally cash-rich but dividend-stingy technology companies starting to pay and increase their dividends, the story gets better. By the end of 2013, the tech sector's number of dividend payers had increased by 68 percent sincd 2002, according to FactSet.

As the economy continues to improve, dividend payers will have more cash to convert to shareholder payments. Consumer discretionary stocks are expected to lead the way in dividend growth, followed by financial companies, according to FactSet.

It's important to remember that in exchange for the reliability of dividend payments, you're not getting full stock-market-index returns. The Vanguard Dividend Appreciation ETF, for example, has lagged the broad S&P 500 index over the past one to five years by roughly 2 to 4 percentage points, depending on the period.

But what you sacrifice in terms of appreciation, you gain in the form of lower volatility.

Dividends provide a modest buffer in the worst markets because they offer steady cash payments to investors. In 2008, when the S&P lost 37 percent, the Vanguard appreciation fund lost only 26 percent. That's not a risk-free return by any means, but a dividend strategy continues to make sense if you're concerned about mixing appreciation with income. The combination of growth and dividends trumps bond returns in most years. (Follow us @ReutersMoney or here Editing by Douglas Royalty)

Comments (0)
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.