If you’re searching for a dividend-paying fund to cushion your portfolio with steady income, you’ll have to look beyond hot yields. That’s because those rich yields usually come with a sharp trade-off for investors in the form of additional risk, according to a recent study from Morningstar. “There is a perception that we have that a lot of people go after income and think this income is safe – that they get the price appreciation component with income tacked on top — that’s not true at all,” said Daniel Sotiroff, senior analyst at Morningstar and co-author of the study ” Searching for Great Dividend Funds .” “There is often a tradeoff in dividends versus price appreciation,” he said. Three main styles The paper identified three main styles of dividend funds. The first is “dividend income,” which offers higher yields compared with the market, but the dividend payments themselves may grow at a slower rate. This could be because the underlying companies within the fund are mature with limited growth prospects – or because these are names with deteriorating business conditions. For companies that offer hefty yields, there’s a risk that dividends may be slashed if they fall on hard times. That could imperil the income investors are expecting. For instance, Morningstar highlighted General Electric , which slashed its dividend in half in late 2017 after its profits slowed and the share price fell. GE’s stock price continued its descent in 2018, and this pushed its dividend yield higher – however, the company wound up cutting dividends again at the end of that year. The second style is “dividend growth,” which involves picking companies that offer lower yields in exchange for higher future payouts. These stocks tend to trade at a higher price multiple compared with the companies that offer higher yields. “Some companies are like Apple and Microsoft ,” said Sotiroff. “They don’t show up in a lot of high yield portfolios, but rather it’s a different type of dividend strategy – a high quality dividend strategy.” Indeed, Apple’s dividend yield is 0.5%, but has grown 8.7% annually over the past 10 years , while Microsoft pays a dividend yield of 0.8%, which has expanded 11.1% a year for the past decade . The third style combines aspects of the other two, seeking both growth and income. In turn, the median trailing 12-month yield for U.S. funds in the “dividend growth and income” cohort tends to land right in the middle: 2.12%, compared with the 2.97% for “dividend income” and 1.53% for “dividend growth,” Morningstar found. Investors studying funds across the three categories will notice that there’s a trade-off between yield and price appreciation. To prove the point, Morningstar compared the Vanguard Dividend Appreciation ETF (VIG) and the Vanguard High Dividend Yield ETF (VYM) , finding that both funds had total returns of roughly 8.6% in the decade spanning 2008 to 2017. While the total returns were similar, VYM posted an end-of-year yield that averaged just over 3.2%, while VIG’s averaged around 2.3%. However, VIG’s price grew at an annual rate of 6.19 percentage points, compared with VYM’s appreciation of 5.26 percentage points a year – assuming investors spent the dividends and didn’t touch the principal. Finding the right fund Investors may be drawn to a fund’s high yield, but they shouldn’t overlook the additional risk of the underlying companies in the portfolio that may cut their dividends, and the prospect of lower price appreciation. Morningstar recommended that investors shopping for passively managed funds consider portfolios with at least 100 stocks, with no more than one-third of the total value in the 10 largest positions. Investors should also aim for funds with low annual turnover ratios – that is, a measurement of the fund’s trading within its holdings. “Great dividend funds typically turn over about 20% to 40% (or less) of their portfolio over the course of a year,” Morningstar noted in its report. Fees also matter: remember that higher expense ratios take a bite out of the total returns you pocket. A good starting point for investors seeking the “right” fund might be to start with Vanguard’s High Dividend Yield ETF (VYM), which provides a reasonably higher yield than the market and includes names that are steady payers, said Sotiroff. “It’s a reasonable strategy that we really like,” he said of VYM. “It’s diversified, and there’s more emphasis on blue-chip stocks paying consistent dividends. It’s also cheap, which is important.” Sotiroff also highlighted Schwab’s U.S. Dividend Equity ETF (SCHD) for investors seeking a starting point in their search for dividend funds. Both VYM and SCHD have an expense ratio of 0.06%. VYM, which tracks the FTSE High Dividend Yield Index, has a total return — capital gains plus reinvested dividends — of 6.2% in 2023. Meanwhile, SCHD, which follows the Dow Jones U.S. Dividend 100 Index, has a year-to-date total return of about 4.4%. “As you take on more yield, you get into something riskier,” he said. “Down the road, you may suffer principal risk.”
This story originally appeared on CNBC
