Funds that invest in dividend-paying stocks won't "wow" investors with eye-popping returns during bull market rallies, but their added yield over time can provide some cushion in devastating bear market drops. From 1926 to March 2009, 44 percent of the total returns of the S&P 500 came from reinvested dividends, according to S&P data. Some blue-chip stocks consistently pay out dividends year after year, and although they can cut their dividends at any time (as many financial companies have), mutual funds that invest in dividend-paying companies can pick and choose to provide a steady stream of income over time.
[See 10 Great Dividend Stocks.]
Stock funds generally aim for capital appreciation, a steady growth of income, or a combination of both. Capital appreciation is what investors generally think of when it comes to returns, but a stable income on the side can be helpful in periods when markets are falling or at a standstill. "There's the capital appreciation, which usually is the bigger component of your total return, and there's also the income portion," says Jeff Tjornehoj, Lipper's research manager for the United States and Canada. "The income portion can really hold you in good stead when the market just isn't moving anywhere."
Different types of mutual funds invest in dividend-paying companies. Equity income funds, for example, invest in what their name suggests—stocks that generally provide income to investors. The average yield of S&P 500 stocks at the end of November was 2 percent, and the average yield of equity income funds was 3.6 percent, according to S&P data. "Dividend-paying stocks help out on the risk component side of things," says Todd Rosenbluth, an equity analyst for Standard and Poor's. "Companies that historically pay dividends tend to have less volatility and have more consistency, which is a positive thing when you're investing in a diversified portfolio."
For investors interested in increasing the income portion of their portfolio, Rosenbluth suggests looking into equity income funds. The S&P MarketScope Advisor lists several equity income funds that it ranks as "S&P five-star funds." Rosenbluth says these are funds that have scored well in a range of measures versus their peers, including long-term performance, the quality and valuations of holdings, manager tenure, and several risk and cost factors. Every S&P five-star equity income fund has a positive risk ranking, which Rosenbluth says is rare for an entire category of funds. "Our approach happens to favor funds that invest in dividend-paying stocks because companies that are dividend paying will tend to have two characteristics that we like," he says.
Rosenbluth cites two Vanguard funds that he thinks illustrate the characteristics of highly rated equity income funds: Vanguard Dividend Appreciation Index Fund (VDAIX), which tracks an index containing companies that have consistently increased their dividends over time, and Vanguard Dividend Growth fund (VDIGX). Both funds invest in a range of companies rated highly by S&P and earn yields higher than the S&P 500 average. For the year to date, the funds have struggled to outperform their index, but both held up much better than most during the downturn.