How Do Choose a Dividend Fund to Invest in?
How Do Choose a Dividend Fund to Invest in?
How Do Choose a Dividend Fund to Invest in?
“One of the most important distinctions among dividend strategies is the way they use dividends to select stocks for a portfolio, which leads to differences in their associated risks,” say Trubey and Morningstar analyst Daniel Sotiroff.
Morningstar classifies dividend funds into three different cohorts:
Dividend income funds focus heavily on dividend yield or income.
Dividend growth funds hold stocks that consistently increase their dividends over time, thus signaling overall resilience and future growth.
Dividend growth and income funds strike a balance between future growth and current income.
There are some important differences between these cohorts, as Sotiroff and Trubey explained in their December 2023 report, “Searching for Great Dividend Funds.”
“Dividend income funds incur more risk than dividend growth funds, though the additional risk doesn’t always show up in performance,” the analysts write. “Dividend growth funds usually bear less risk, but they usually capture less of the market’s upside.”
Portfolios focused on dividend income are frequently value-oriented. However, the highest-yielding portfolios often trade in the cheapest, sometimes riskiest, stocks in the market. They are affordable because the market expects those stocks to grow slower, if at all. Some of the stocks in these portfolios might be facing existential threats to their business. Their prices may have further to fall, and future dividend payments may get cut if the company decides to preserve cash.
Dividend growth funds usually avoid such stocks. They look for firms with greater profitability and strong competitive advantages that usually translate into better performance during volatility. However, such stocks may lag the broader market during rallies. Dividend growth funds typically underperform the market during periods of exceptionally strong growth, when expensive stocks that pay few, if any, dividends fuel the market’s rise.
Active or Passive, Mutual Fund or ETF?
Among other things, investors want to consider whether they prefer a passively managed dividend fund or an actively managed one. Passive funds offer lower fees, which may be attractive. However, the rules governing a passive fund mean the fund is restricted in how it can respond to market shifts. Active fund managers have the leeway to modify a fund to keep it aligned with investors’ expectations.
Mutual funds may have minimum investment requirements, while ETFs typically do not. Investors who value trading flexibility or who may have few dollars to invest might prefer an ETF.
Investors should look for funds with the following characteristics, according to Sotiroff and Trubey:
Dividend funds should hold at least 100 stocks and have one third or less of their assets parked in their 10 largest holdings. (Active managers can get away with fewer, provided they’re a prudent judge of the stocks they ultimately select for their portfolios.)
Dividend funds should keep turnover within reasonable limits, ideally around 40% or less. That prevents a fund from racking up trading costs and can indicate that it isn’t churning through stocks to chase after dividend-payers.
“Low fees and broad diversification tend to define the top-performing dividend funds, and they are among the most important traits to consider when selecting a fund,” Sotiroff and Trubey say. “Well-constructed dividend funds, whether active or passive, should consistently deliver the style that they’re attempting to achieve while controlling the risks they take.”
“One of the most important distinctions among dividend strategies is the way they use dividends to select stocks for a portfolio, which leads to differences in their associated risks,” say Trubey and Morningstar analyst Daniel Sotiroff.
Morningstar classifies dividend funds into three different cohorts:
Dividend income funds focus heavily on dividend yield or income.
Dividend growth funds hold stocks that consistently increase their dividends over time, thus signaling overall resilience and future growth.
Dividend growth and income funds strike a balance between future growth and current income.
There are some important differences between these cohorts, as Sotiroff and Trubey explained in their December 2023 report, “Searching for Great Dividend Funds.”
“Dividend income funds incur more risk than dividend growth funds, though the additional risk doesn’t always show up in performance,” the analysts write. “Dividend growth funds usually bear less risk, but they usually capture less of the market’s upside.”
Portfolios focused on dividend income are frequently value-oriented. However, the highest-yielding portfolios often trade in the cheapest, sometimes riskiest, stocks in the market. They are affordable because the market expects those stocks to grow slower, if at all. Some of the stocks in these portfolios might be facing existential threats to their business. Their prices may have further to fall, and future dividend payments may get cut if the company decides to preserve cash.
Dividend growth funds usually avoid such stocks. They look for firms with greater profitability and strong competitive advantages that usually translate into better performance during volatility. However, such stocks may lag the broader market during rallies. Dividend growth funds typically underperform the market during periods of exceptionally strong growth, when expensive stocks that pay few, if any, dividends fuel the market’s rise.
Active or Passive, Mutual Fund or ETF?
Among other things, investors want to consider whether they prefer a passively managed dividend fund or an actively managed one. Passive funds offer lower fees, which may be attractive. However, the rules governing a passive fund mean the fund is restricted in how it can respond to market shifts. Active fund managers have the leeway to modify a fund to keep it aligned with investors’ expectations.
Mutual funds may have minimum investment requirements, while ETFs typically do not. Investors who value trading flexibility or who may have few dollars to invest might prefer an ETF.
Investors should look for funds with the following characteristics, according to Sotiroff and Trubey:
Dividend funds should hold at least 100 stocks and have one third or less of their assets parked in their 10 largest holdings. (Active managers can get away with fewer, provided they’re a prudent judge of the stocks they ultimately select for their portfolios.)
Dividend funds should keep turnover within reasonable limits, ideally around 40% or less. That prevents a fund from racking up trading costs and can indicate that it isn’t churning through stocks to chase after dividend-payers.
“Low fees and broad diversification tend to define the top-performing dividend funds, and they are among the most important traits to consider when selecting a fund,” Sotiroff and Trubey say. “Well-constructed dividend funds, whether active or passive, should consistently deliver the style that they’re attempting to achieve while controlling the risks they take.”