Dividend Funds Can Add Income, and Risk, to Your Portfolio

You can increase your investment income by buying a mutual or exchange-traded fund that owns dividend-paying stocks. Whether you should is a thornier question.

Dividends can be dependable — many companies increase theirs year after year — but the prices of the stocks to which they’re linked won’t necessarily be so steady. A fund or E.T.F. of dividend payers provides no guarantee against losses.

So far this year, the S&P Dividend Aristocrats Index — an index of dividend payers in the S&P 500 — lost 2.6 percent year-to-date through Sept. 30, even after factor in those dividends. The S&P 500 returned of 5.57 percent, including dividends.

What’s more, the pandemic has increased the risks that dividends will be cut as some companies’ earnings and cash flow diminish.

“If you’re Walt Disney and you had to close all your parks, your cash flow dried up,” said Scott L. Davis, lead manager of the Columbia Dividend Income Fund. Disney announced in May that it was suspending its dividend for the first half of its fiscal 2020.

Dozens of companies have slashed their dividends this year.

“We’ve seen more cuts and suspensions in 2020 than we had in the prior 10 years,” said Christopher Huemmer, a senior investment strategist at Northern Trust Asset Management.

And the upheaval may not be over, especially with flu season overlapping with the pandemic this fall.

“If there’s another huge round of Covid and lots of shutdowns, I think you’ll see lots more companies get pinched and say they can’t afford their dividends,” said Clare Hart, lead manager of the JPMorgan Equity Income Fund.

Despite these heightened risks, Jennifer Ellison, a financial adviser at Bingham, Osborn & Scarborough in San Francisco, said she understands why people might want to add a fund or E.T.F. of dividend payers to their portfolios.

“With bond yields where they are, everybody’s asking where they can find more income,” she said.

Interest rates are lingering near record lows. The 10-year Treasury security, an interest rate benchmark, was yielding about 0.7 percent on Sept. 30.

In contrast, the yield of the Vanguard High Dividend Yield E.T.F., which passively tracks the FTSE High Dividend Yield Index, was more than five times as high, at 3.59 percent. The fund has returned an annual average of 11 percent over the last decade as of Sept. 30.

Dividends can help plump a portfolio’s return. Long term, they’ve accounted for about 40 percent of the total return of the stocks in the S&P 500, said Mike Barclay, a co-manager of the Columbia Dividend Income Fund.

But investment professionals caution that focusing solely on dividend yield — a company’s annual dividend divided by its stock price — as a marker of a good investment can be a trap. Because of how yield is calculated — the ratio rises when a stock price falls — a sinking stock can result in a seemingly enticing yield.

“The companies with the highest yields can have very high levels of risk,” said Omar Aguilar, chief investment officer for passive equity and multi-asset strategies at Charles Schwab. “You can have an attractive dividend yield in a company about to go bankrupt.”

That quirk of yield is why the managers of active dividend funds and organizers of dividend E.T.F.s add quality screens to their stock selection.

Daniel Sotiroff, an analyst for Morningstar, said funds and E.T.F.s could impose an explicit screen, like investing only in companies that achieve a certain return on equity, or an implicit one, like allocating holdings according to market capitalization.

The latter approach means companies with the heftiest market caps will be the largest stakes in the fund, and those outfits “tend to be more stable and more profitable,” Mr. Sotiroff said.

A quick-and-easy way to assess the quality of a fund’s holdings is to compare its overall dividend yield with that of the Vanguard High Dividend Yield E.T.F., he said. That indexed Vanguard offering is highly diversified, with 424 holdings, and market-cap weighted.

“If you’re going after a fund with a higher yield than that, you may be taking on more risk than you might want,” he said.

A passively managed fund that explicitly screens for quality is the SPDR S&P Dividend E.T.F. It holds only companies in the S&P 500 that have increased their dividends for at least 20 consecutive years.

“The average amount of years these firms have increased their dividend is 38,” said Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors. “Nine of them have increased it for more than 55 years.”

Many dividend funds and E.T.F.s strive for a balance between securing dividends and betting on stocks with promising prospects.

Mike Reckmeyer, who manages both the Hartford Equity Income Fund and about 70 percent of the Vanguard Equity Income Fund, said his lodestar was dividend sustainability. (The rest of the latter fund is handled by Vanguard’s quantitative equity group.)

“We like to see growth out of the companies, and we expect dividends to grow along with earnings,” he said. “We’re willing to sacrifice some yield for that growth element.”

Mr. Reckmeyer said he has lately gravitated to pharmaceutical stocks, like Johnson & Johnson and Pfizer, because in addition to delivering solid dividends, they’ve been good values.

“Pharmaceutical stocks are trading at the largest discount to the market in 15-plus years,” he said. “So you have growing dividends, attractive balance sheets and the valuations.”

Mr. Reckmeyer’s funds have both returned an annual average of about 11 percent over the last decade.

John D. Linehan, manager of the T. Rowe Price Equity Income Fund and the John Hancock Equity Income Fund, likewise seeks a combination of durable dividends and earnings growth.

In the years ahead, he said, he expects to see that happen in a sector some investors might find surprising: utilities. Utilities have long been known for their dividends. Mr. Linehan said they’re just as attractive today for their growth prospects.

“You can argue utilities will benefit from our society’s higher reliance on the electric grid — they’re going to be a part of the solution for decarbonizing our economy,” he said. A widespread switch, for example, to electric vehicles would require more electricity.

Both of Mr. Linehan’s funds have returned an annual average of about 9 percent over the last decade.

Something to note if you’re considering a dividend fund is that the holdings can resemble those of value funds, said Ms. Ellison of Bingham, Osborn & Scarborough.

Value funds often invest in mature companies, and mature companies typically pay dividends. Managers of value funds seek stocks trading for less than their estimate of the worth based on a measure like the price-to-book or price-to-earnings ratio. This approach often leads them to out-of-favor companies or industries.

So buying a dividend fund or E.T.F. could mean increasing your exposure to that portion of the market, she said. So if you add a dividend fund to your holdings, you might want to substitute it for a value-oriented fund you already own.

Before venturing into any dividend fund or E.T.F., you should reassess your budget, said Jennifer Lane, owner of Compass Planning Associates in Boston.

Reducing your spending and the resulting drain on your investments is more prudent than trying to “juice what’s coming out of your portfolio” with a dividend fund, Ms. Lane said.

“You can’t just increase your dividend yield and spend more,” she said. If, as is typical, you’ve been relying on bonds for income, “you’re taking a lot more risk with dividend-paying stocks.”

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