How to Choose a Dividend Fund

Investors who want the stability of regular dividend income—people in or close to retirement, income investors, or those with a long time horizon—can find dividend funds and dividend exchange-traded funds to be a great long-term investment.

How Do Dividend Funds and Dividend ETFs Work?

A dividend fund or ETF holds a significant amount of dividend-paying stocks. A dividend fund collects the dividends it gets from its stock holdings, then distributes them to shareholders based on the number of shares owned.

Using dividend funds, investors can generate steady income from stable, profitable companies across a range of industries.

Many companies, especially those in the energy, utilities, and financial-services sectors, pay dividends. Technology firms and other swiftly expanding companies often don’t pay dividends, because any excess profits are used to grow their companies.

You might already have plenty of dividend stocks in your portfolio without knowing it. Dividend-paying companies are often larger firms whose stocks are popular holdings among large-cap mutual funds and exchange-traded funds. So, investors who own large-cap funds may already hold a sizable position in dividend stocks. For example, Vanguard Dividend Appreciation VIG and the broad-based large-cap Vanguard Total Stock Market ETF VTI share the same two top holdings, both of which are dividend-paying stocks: Microsoft MSFT and Apple AAPL.

Should I Invest in Dividend Funds?

There are several benefits to investing in dividend funds.

• Cash flow: Dividend funds’ distributions provide investors with a stable and consistent source of income.
• Yield: These funds often generate higher dividend yields than broad market indexes, which can appeal to income-oriented investors.
• Resilience: According to Morningstar analyst Todd Trubey, “Dividend funds tend, as a group, to hold up better in downturns than other equity funds.”

To decide whether dividend funds are a good choice for your portfolio, assess your investment goals, risk tolerance, and financial situation. Are you looking to get regular income, capital growth, or a combination? Understanding your goals will help you narrow your options.

How Do I 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 explain 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 little, 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.”

Fees

Fees are a critical consideration, as they directly eat away at a fund’s yield and total return. According to Morningstar’s research, the best-in-class index-tracking dividend income and dividend growth funds tend to charge the lowest expense ratios in their respective cohorts. But while passively managed funds may offer lower fees, there are other possible charges to consider. A fund may also levy account maintenance fees, account transfer fees, or redemption fees. It’s important to understand the total cost of investing in a fund before committing your money to it.

The bottom line on fees, as Russ Kinnel, Morningstar director of ratings, explains, is, “Be sure you know of any additional fees associated with your investment. They should appear when you go to make a trade. Each brokerage has different transaction and account maintenance fees that may vary among funds. For example, many brokerages have certain funds that are part of No Transaction Fee lineups and some that do cost money—often different share classes of the same fund. So be sure to look for a note that says ‘NTF’ or ‘Transaction Fee.’ ”

Find a Quality Benchmark

Sotiroff and Trubey also provide a practical recommendation so that you can become your own analyst. “A simpler way to find great dividend funds is to use a great benchmark that can help gauge the riskiness of others,” they note.

Vanguard High Dividend Yield ETF VYM, which has a Morningstar Medalist Rating of Gold, is a great starting point. It strikes a reasonable balance between risk and yield, and most active managers have had trouble performing better. Funds promising higher yields will incur greater risks to provide that yield, so those that combine growth and income characteristics, such as Vanguard High Dividend Yield ETF, should hold up better in the long run. Along the same lines, investors interested in an actively managed portfolio should start with Silver-rated JPMorgan Equity Income HLIEX.

How to Find the Best Dividend Funds

• Our regularly updated article, The Best Dividend Funds, provides our lists of the best low-cost dividend ETFs and mutual funds, all with Morningstar Medalist Ratings of Silver or Gold.
• Some investors may prefer a list of highly rated funds that invest in dividend stocks around the globe, not just in US names. Using the Morningstar Investor Screener, select Investment Type (either ETF or Mutual Fund), enter the Keyword “dividend” in the Search Securities section, set Asset Class to International Equity under the Criteria section, and check both Gold and Silver beneath Morningstar Medalist Rating in the Ratings section.
• Want to find a complete list of dividend stock ETFs or mutual funds available today, not just those with our highest Medalist Ratings? Using the Morningstar Investor Screener tool, select Investment Type (either ETF or Mutual Fund) and enter the Keyword “dividend” in the Search Securities section.