How Dividend Payers Boost Returns and Reduce Risk

With bond yields so low, these shares can be a good alternative for income-seeking investors.

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Stock investors can aim to tamp down risk and lift returns by giving often-overlooked dividend-paying stocks some love.

When the market booms, these stocks tend to have a somewhat muted reaction; on the other hand, the income stream tends to buoy them during rough patches. "Slow and steady wins the long race," writes Daniel Peris, a portfolio manager with Pittsburgh-based Federated Investors, in his 2011 book The Strategic Dividend Investor.

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Moreover, with bond yields so low, these shares can be a good alternative for income-seeking investors. Many dividend yields currently exceed the 2 percent return on the 10-year U.S. treasury. Healthcare and pharmaceutical giant Johnson & Johnson, for instance, currently pays an annual dividend of about $2.28 per share, a yield of about 3.7 percent.

Yes, dividend-paying stocks do carry a greater risk than bonds. But keep in mind that whenever interest rates finally start climbing, bonds will be in for a fall. At the moment, experts say, many companies are sitting on cash that might allow them to raise their dividend. Through the end of 2012, at least, shareholders can benefit from a favorable tax rate cap (15 percent for most people) on dividend earnings.

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To many analysts, the commitment to paying a dividend can be a telling sign of a company's financial discipline and transparency. Dividends "really put some financial sobriety on a lot of management teams," says Don Wordell, manager of the RidgeWorth Mid-Cap Value Equity Fund, which holds only stocks paying dividends and has returned 3 percent annually over the last five years. He advises investors interested in individual stocks to look not only for a history of raised dividends but also of payouts that continue through varying economic cycles. Johnson & Johnson has increased its dividend each year for almost five decades. Be careful to check that a high dividend yield isn't just the result of a drop in the stock price. "Just because it has a high yield doesn't necessarily mean it's golden," Wordell says.

To find strong dividend-paying equities across a range of sectors, take a look at funds that focus on companies that grow their dividends over time. The Dividend Growth Advisors Rising Dividend Growth Fund, for instance, has a 4 percent annual return over the last five years. The fund invests in a range of companies that have paid dividends for at least a decade and that increase those rates by an average of 10 percent each year. Top holdings include IBM, McDonald's, and Cardinal Health.

Fidelity, Vanguard, and T. Rowe Price also offer dividend-growth mutual funds. Exchange-traded funds tied to dividends include the Vanguard Dividend Appreciation ETF and the iShares Dow Jones Select Dividend Index Fund.

The benefits of dividend-paying stocks in any portfolio shouldn't be understated, says Hank Smith, chief investment officer with Pennsylvania-based investment manager Haverford Trust Co. "It's cash out of the company's coffer into the shareholder's. It's not words, it's action."

Here's a look at the U.S. News Best Fit Income ETFs:

1. Wisdomtree Dividend ex-Financials Fund (DTN)

2. iShares Dow Jones Select Dividend Index Fund (DVY)

3. Wisdomtree Total Dividend Fund (DTD)

4. SPDR S&P Dividend ETF (SDY)

5. First Trust Morningstar Dividend Leaders Index Fund (FDL)