Yields Can Be Risky When They Are High. What to Look for in Dividend Funds

If you're in the market for a dividend-paying fund to add a layer of consistent income to your investment portfolio, it's crucial to look beyond enticing high yields. According to a recent study from Morningstar, those seemingly attractive high yields often come at the cost of increased risk for investors.

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Morningstar's senior analyst, Daniel Sotiroff, co-author of the study titled "Searching for Great Dividend Funds," dispelled the common misconception that high-income investments provide a secure combination of price appreciation and additional income. He emphasized that there is typically a tradeoff between dividends and price appreciation.

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The study identified three primary styles of dividend funds. The first category, "dividend income," offers higher yields compared to the market, but the dividend payments may grow at a slower rate. This could be due to the underlying companies within the fund being mature with limited growth prospects or facing deteriorating business conditions. The risk here is that companies offering substantial yields might slash dividends if they encounter financial difficulties.

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For instance, Morningstar pointed out General Electric, which halved its dividend in late 2017 after experiencing slowed profits and a falling share price. Despite the subsequent increase in GE's stock price, the company eventually cut dividends again at the end of the year.

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The second category is "dividend growth," where companies offering lower yields promise higher future payouts. These stocks typically trade at higher price multiples compared to higher-yield companies. Examples of such companies include Apple and Microsoft, which, despite having low dividend yields, have seen significant annual dividend growth.

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The third style combines aspects of both dividend income and dividend growth, seeking a balance between growth and income. Morningstar found that the median trailing 12-month yield for U.S. funds in the "dividend growth and income" category tends to land between the yields of "dividend income" and "dividend growth."

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To illustrate the tradeoff between yield and price appreciation, Morningstar compared the Vanguard Dividend Appreciation ETF (VIG) and the Vanguard High Dividend Yield ETF (VYM). Both funds had similar total returns over a decade, but VYM offered a higher yield, while VIG exhibited greater price appreciation.

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Morningstar recommended that investors consider passively managed funds with at least 100 stocks, limiting exposure to the 10 largest positions to one-third of the total value. Additionally, funds with low annual turnover ratios and low expense ratios are preferable, as higher fees can erode total returns.

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For investors seeking a starting point, Morningstar suggested looking into Vanguard's High Dividend Yield ETF (VYM) and Schwab's U.S. Dividend Equity ETF (SCHD). These funds offer reasonable yields, diversification, and an emphasis on blue-chip stocks with consistent dividends, all at a low expense ratio.

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Sotiroff highlighted VYM as a reasonable and well-diversified strategy, emphasizing its focus on blue-chip stocks with consistent dividends. He also recommended Schwab's SCHD for investors initiating their search for dividend funds. Both funds boast an expense ratio of 0.06%, making them cost-effective options. However, Sotiroff cautioned that as investors pursue higher yields, they also expose themselves to increased risk and the potential for principal risk down the road.