Morningstar lists over 150 equity mutual funds and ETFs that focus specifically on companies that pay dividends. But why should advisors consider a dividend-oriented fund rather than a traditional equity income or growth-and-income fund?

Because some of those equity-income and growth-and-income funds may hold preferred stocks, convertibles, and sometimes even bonds, says Jeff Layman, chief investment officer and principal at Springfield, Mo.-based BKD Wealth Advisors.

Dividend-oriented ETFs and mutual funds are more likely to own only stocks, and investors know that those stocks represent companies that are able to consistently produce cash flow for their shareholders.

SPLIT DECISION

Funds that concentrate on dividend-paying stocks may choose to feature either companies with high current dividends or those with the potential for dividend growth. “For clients needing greater current cash flow, a high-dividend fund may be more appropriate,” says Layman. But, he says, that strategy will tend to underperform during bull markets.

Dividend growth funds typically invest in companies with a history of increasing payouts. Layman says a dividend growth strategy would be more appropriate for those who want “a more conservative stock exposure than offered by the broad market, along with the opportunity to build toward a strong income stream later on.”

Layman’s firm uses both types of dividend funds, depending on the goals of the particular client. For clients that are looking for high current dividends, his firm uses Federated Strategic Value Dividend and Lord Abbett International Dividend Income. For dividend growth, the firm uses Vanguard Dividend Growth. The two higher-dividend funds recently had trailing 12-month yields of 3.09% and 4.35%, respectively, according to Morningstar, while the dividend growth fund had a yield of 1.84%.

Layman uses the mutual funds because the managers will diversify the fund’s holdings. Some dividend-oriented ETFs, in contrast, simply buy the highest yielding stocks, without regard to sector diversification.

STEADY SATISFACTION

Russ Lane, a founding member of Compass Financial Resources, a planning firm in Olathe, Kan., also prefers active management in a dividend stock fund. His firm has used Franklin Rising Dividends Fund for more than 20 years, and Lane says his clients typically have 10% to 20% of their portfolios in the fund. (His firm does not allow any client to have more than 20% of their portfolio in any fund.) Morningstar recently put the fund’s trailing 12-month yield at 1.12%.

“One reason that we’ve been pleased with this fund,” says Lane, “is because it avoids companies that don’t pay rising dividends. This has allowed it to miss some stocks that have collapsed. The rising dividend idea is a good story for clients, especially retirees and pre-retirees. They often like the conservative approach, owning companies that have delivered consistent, steady growth.”

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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