How to Find a Great Dividend Fund

Dan Sotiroff and Todd Trubey, senior manager research analysts for Morningstar Research Services, discuss what makes a great dividend fund, the trade-offs that are costing some investors, and the risks to watch for.

Dividend Income, Dividend Growth, and Dividend Income and Growth

Dividend Fund Risks

Should Dividend Yield Be a Top Priority?

Dividend Funds vs Passive Options

What Advantage Do Actively Managed Funds Have Over Broadly Diversified Passive Funds?

How to Find a Great Dividend Fund

Passively Managed Dividend Fund Picks

Actively Managed Fund Picks

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The Best Dividend Funds

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Read what our team is writing:

Ivanna Hampton

Daniel Sotiroff

Todd Trubey

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Ivanna Hampton: Dividend funds attract investors for a lot of reasons. And a big one is the regular income. But dividend funds have different styles, risks, and goals. How do you find the one that’s right for you? Morningstar researchers have investigated what makes a great dividend fund. Dan Sotiroff is the lead author, and Todd Trubey is the co-author. Both are senior manager research analysts for Morningstar Research Services.

Thanks, Dan and Todd, for being here today.

Dan Sotiroff: You're welcome.

Todd Trubey: Thanks.

Hampton: Your study separates dividend funds into three groups – dividend income, dividend growth, and dividend income and growth. Dan, what makes these styles different from each other?

Sotiroff: Perhaps maybe just a quick step back. The reason we did that is there's a lot of dividend funds that just say dividend, right? So, it's kind of a blunt descriptor. It doesn't really tell you what's actually going on in the portfolio and how would you use this. So, we thought carving the mountain into three groups like that gets a little bit more granular as to what these funds are actually doing. So, the differences between them, like let's start with dividend growth, those are going to be like your highly profitable blue chip companies, think of like Apple, Microsoft right now, they're going to end up in more of that dividend growth. They've been paying dividends for a long period of time, and they have a history of increasing their dividends over time.

Dividend income, that's synonymous with your high dividend yield type stocks. So, you think of like a Coca-Cola or something like that. Those are more value-oriented strategies. So, when you look at the broad ends of the spectrum, growth versus income, they're very, very different portfolios at the end of the day. And then that other one that you mentioned, growth and income, it's kind of a tweener. It's a combination of the two and it's just sort of this middle ground that has the characteristics of both of those squashed together, but it's not strong in either one, I guess I would say.

Hampton: And the risks vary among these?

Sotiroff: For sure. Yeah. So, when you look at your dividend growth type funds, those tend to be again, these big, stable, profitable companies. They tend to be maybe a little bit less risky than the market. Not a lot, but you do see periods when the market goes through a drawdown, that might be a little bit safer play. But again, they're profitable, they're growing, there's still a lot of growth left in them. When you go to the income side, the high dividend yield type strategies, that's a little bit more risky or those companies tend to be slower growth. So, you think of like a Coca-Cola dominates its industry, right? There isn't a lot of opportunity to grow. But you can also get into riskier stocks. So, companies that maybe their fundamentals are really struggling, they're going through a bad business cycle or they're in a bad industry or something like that. Their fundamentals might be deteriorating. So, they're a little bit riskier, but the yields tend to be a little bit higher. So that's really, think of income as being a little bit riskier, dividend growth tends to be a little bit of safer play.

Hampton: And then the income and growth.

Sotiroff: And then the income and growth, they're kind of in between. Yeah.

Hampton: So why should investors not make dividend yield their top priority?

Sotiroff: So, it was kind of like what I was saying before. When you get into yield, it's very, very easy to get into chasing companies that have really high yields. And the thing is, those really high yields are not from companies that are growing their dividends at alarmingly high rates. It's often because the price has come down by a lot. And usually that follows after their fundamentals are deteriorating. So, one of the companies we highlighted in the paper was GE, who a couple of years ago, went through a really bad business cycle. Their price declined and it looked like they were paying out a really nice yield. But what you saw in the subsequent months and years is that they actually ended up almost completely eliminating their dividend payments. So that's one of the risks you can get into with those high-income type companies as you may not see that dividend actually materialize a few months down the road.

And then, just going from point A to point B, it's going to be a bumpy ride. They're volatile companies at that. So that's one of the things you have to really be aware of when you get into the high yield companies. Again, the growth companies, a little bit less riskier play. Those are stable, profitable companies at the end of the day.

Hampton: And Todd, an investor who spends their dividends instead of reinvesting them is likely making a trade-off. Can you explain what's happening?

Trubey: Absolutely. So, when you measure total return of stocks, there are two components to that. There's your capital return, which is the price goes up. And then there's income return, which is dividend yield, right? And together, that's the total return. But it assumes you're reinvesting dividends. If you don't reinvest your dividends, you're not going to get all of that total return that you might see. So, let's make this real simple. Over a long period of time, the stock market returns about 10%. And most people think that dividends reinvested count for about 40% or maybe even more of that. So, if you don't reinvest your dividends, you're not going to see 10%. It's going to be a lot more like 6%.

Hampton: Got you. Well, your research compared dividend funds to passive options like Vanguard Total Stock Market ETF. Todd, what were the results, and should an investor just choose a benchmark?

Trubey: Absolutely. It's a good question. So, in the paper, we took the Vanguard Total Stock Market, and we compared it to the median of the three different categories – dividend growth, growth and income, and then income. And we looked at over two time periods, two five-year periods from 2013 to 2018, 2018 to 2023. And in both cases, both times, the Total Stock Market Index ETF beat the average of all those income categories. And there's good reason. These are large cap companies. It's a really efficient market, so it's really hard to beat before fees. But of course, then there are fees, and if there's an active manager, that's going to be a higher fee. The ETF that's really cheap just gives you most of that return in that efficient market. So oftentimes, going with a passive option is a really good idea.

Hampton: And what edge do actively managed funds that focus on dividend paying stocks have over the cheap, broadly diversified passive funds?

Trubey: Sure, there's two categories of advantages that they have. One is flexibility, and then the other is investor preference. So, under the heading of flexibility, an active manager can automatically avoid some of those dangerous stocks that Dan was talking about earlier, a yield of 9%, no, I'm going to stay away, it's going bankrupt. They also might be able to dodge a company that's about to cut its dividend. That's a really bad sign when that kind of thing happens. Another thing that they can do with flexibility is they can pile into really strong companies that have grown their dividend over time and possibly outperform.

The other category where you might want to go with an active manager is investor preference. So, one thing that can happen is they have a target yield. We're going to you 2% no matter what. That would allow a retiree who is not reinvesting dividends to have a predictable income stream, or there might be a flexible income, but it won't go beneath a certain level. And then the other thing that they can do is provide a good risk-return ratio. You see that a lot with dividend growth strategies where they can give you this really nice low downside, good upside possibility.

Hampton: So, Dan, what are some guidelines to help the audience find a great dividend fund?

Sotiroff: Sure. So, we could wax philosophical about all the different risk metrics and stuff that we look at. I don't think that's practical for a lot of people. For one, it takes a lot of time. And two, a lot of that data we're using just is not readily available. We have lots of data sources we can pull from that. A lot of individual (data) we just can't access at home. So, the cheat code for all of this, I guess if you want to put it that way is, what I always tell people is, well, Vanguard has some really good dividend funds right now. So, whether you're looking at dividend growth or dividend income, they got great options. So, on the growth side, Vanguard Dividend Appreciation ETF, there's also an international version of that one. The tickers are VIG and VIGI. Those are great ones to start with. That will give you a pretty good benchmark of what a dividend growth fund looks like. On the dividend income side, same sort of thing. If you go with Vanguard High Dividend Income ETF, ticker is VYM, and then the international version, those are pretty good benchmarks for a pretty solid high dividend yield fund. That gives you a higher yield on the market, but also sort of controls for some of those risks that I was talking about before. So that's key in the high yield space.

From there, if you take on incrementally higher yield, you are taking on incrementally higher risks. So that's sort of how I tell people. It's like, you can vary from those, but just be aware, you may be in for a surprise if the market goes into a downturn or something like that. So that's sort of a starting point. They're great options if you want to stick with them, but that's also a good way to size up other dividend funds that are out there.

Hampton: So, we got the guidelines. Let's hear about some passively managed dividend funds that are top marks for Morningstar.

Sotiroff: Sure. So, the ones I just mentioned from Vanguard are all index tracking. So those are great options. The other ones we really, like, Schwab has some dividend funds. So, Schwab U.S. Dividend ETF, ticker SCHD. It's very similar to the Vanguard High Dividend Income ETF. You get a slightly higher yield than the market. It also has a defensive characteristic to it. So, it outperforms when the market tends to go into a downturn, but it tends to lag when we're in strong rally like we had last year. So, it underperformed last year a little bit. But that's expected. They also have an international version of that if investors are interested in that. So those are the other passively managed options I would really steer people toward.

Hampton: And Todd, let's bring you back in here. What actively managed funds should investors consider?

Trubey: Sure, I'll talk about two. There's JPMorgan Equity Income. Its best share class is Silver-rated. And what we really like there is it's had a very sturdy yield over time. We really like the risk management and deep research that they do on holdings. Now the lead manager, Clare Hart, is going to retire in this fall, but they've had a good succession plan, and we think Andy Brandon and David Silberman, who are co-managers are going to be able to take charge. They know how to run the fund and we think it's going to continue to be strong. In dividend growth, there's T. Rowe Price Dividend Growth. What we like about that one is manager Tom Huber has been able to construct this really great risk-reward matrix. It outperforms the vast majority of its peers over time, but over that same time period, it also has much lower volatility. So, we think that that's one that investors can comfortably hold for a long time and it's Gold-rated.

Hampton: Well, Dan and Todd, thanks for coming to the table and explaining what makes a great dividend fund.

Sotiroff: You're very welcome.

Trubey: Thanks for having us.

Hampton: That it’s for this week. Thanks for listening. If you enjoy hearing market trends and analyst insights on our podcast, feel free to leave a five-star review on Apple Podcasts. It will help others find us. Thanks to senior video producer, Jake VanKersen, video producer, Daryl Lannert, senior audio engineer and producer, George Castady, and craft editor and cinematographer, David Ettinger. I’m Ivanna Hampton, a lead multimedia editor at Morningstar. Take care.