Fund Fad: Dividends

By Daniel Kadlec

Never mind that dividend-paying stocks have been left in the dust lately. Their favorable tax treatment makes them a compelling story for at least the next few years and possibly much longer. But before jumping in, you'll want to take a good look at what you're buying. Dividend strategies vary for different investors, and a slew of new dividend-oriented mutual funds are confusing what should be a fairly simple theme.

When it comes to dividends, two things have always been important: they must be secure, and they must rise over time. Any number of proven income-oriented stock funds can help you find companies whose dividends meet those standards. Among the best are Dodge & Cox Stock and T. Rowe Price Equity Income, both of which have low costs, solid long-term results and managers with long tenures.

But there's a new consideration as well: this summer the tax rate on dividend income was cut to as little as 15% from as much as 39%. Older funds do not have a mandate to invest in dividends that qualify for the lower rate. So they may hold real estate investment trusts (REITs), certain foreign stocks, preferred shares and even bonds, for which dividends remain taxable at higher rates. Good managers will probably shift accordingly. Still, there is a new generation of funds responding to the tax changes.

At least 19 dividend-oriented funds have been launched since last December, enlarging that universe by a third, reports fund tracker Morningstar. On the radar of these funds are companies like Citigroup and Microsoft, which are dramatically raising dividends. Citi boosted its payout 75%; Microsoft paid its first-ever dividend in March and then doubled it on Sept. 12. Eventually, fund investors will want to seize on this trend. The fund industry isn't exactly making things simple. Even some of the new dividend funds invest in REITs. Others trade actively and could saddle you with a tax liability. Some managers seek companies that don't yet pay a big dividend but probably will. Others stick to those that already have a large payout.

Each strategy is appropriate--for the right investor. You might even do best with a few quality high-yield stocks. Why? It's difficult to find a proven stock fund that yields more than 2%, yet you can get yields of 4% or more with shares of Dow Chemical (4.1%) or FleetBoston (4.7%). Individual stocks also let you sidestep fund fees. What you give up is diversification, which provides shelter from things like Kodak's 72% dividend cut last month.

Fund investors looking for an immediate income stream are bound for disappointment. I could find only one proven dividend fund with a yield above 2%: American Funds Washington Mutual (2.1%). The just launched Alpine Dynamic Dividend Fund hopes to fill this void, aiming for a yield above 4%. But its strategy calls for heavy turnover in a third of the portfolio as it tries to capture dividends and then sell. Alpine Management is adept at tax efficiency. Yet heavy trading leaves investors vulnerable to a tax bill from short-term gains.

One promising new fund is Vanguard Dividend Growth, which is the old Vanguard Utilities Income. It has broadened beyond utilities and focuses on companies that pay big dividends or are likely to start paying them. It boasts low costs and has valuable tax losses left from the old fund to offset future gains and boost returns.

The best way to look at dividend funds is from a long-term, total-return perspective. There is nothing wrong with a 2% yield if the payout rises every year along with the share price. In time, you will end up with a nice income stream and capital gains to boot. But you have to start now and be patient. And first you need to make sure you know what you're buying.