What investors need to consider when choosing a dividend-paying fund

For investors who want income, dividends may provide an answer.

Dividends are corporate profits that companies pay to shareholders in the form of either cash or stock.

In comparison to other income-paying investments — such as certificates of deposit, bonds or Treasurys — dividends may provide the opportunity for more appreciation, said Leanna Devinney, vice president and branch leader at Fidelity Investments in Hingham, Massachusetts.

“Dividends can be very attractive because they offer the opportunity for growth and income,” Devinney said.

Dividend investment options may come in the form of single company stocks or dividend-paying funds, like exchange-traded funds or mutual funds.

With individual stocks, it’s easy to see the dividend a company may offer in exchange for owning its share, Devinney said. Notably, not all companies pay dividends.

However, dividend-paying funds like ETFs or mutual funds may provide a broader exposure to dividend securities, often at lower costs, she said.

For investors who are considering putting a portion of their portfolios in dividend-paying strategies to fulfill their income-seeking goals, there are some things to consider.

Generally, there are two types of dividend funds from which to choose, according to Daniel Sotiroff, senior analyst for passive strategies research at Morningstar.

The first group focuses on high dividend yield strategies. Dividend yield is how much a company pays in dividends each year compared to its stock price. With high-yield strategies, the investor is trying to get higher income than the market generally provides, Sotiroff said.

High-yield dividend companies tend to have been around for decades, like Coca-Cola Co., for example.

Alternatively, investors may opt for dividend growth strategies that focus on stocks expected to consistently grow their dividends over time. Those companies tend to be somewhat younger, such as Apple or Microsoft, Sotiroff said.

To be clear, both of these strategies have trade-offs.

“The risks and rewards are a little bit different between the two,” Sotiroff said. “They can both be done well; they can both be done poorly.”

If you’re a younger investor and you’re trying to grow your money, a dividend appreciation fund will likely be better suited to you, he said. On the other hand, if you’re near retirement and you’re looking to create income from your investments, a high-yield dividend ETF or mutual fund is probably going to be a better choice.

To be sure, some fund strategies combine both goals of current income and future growth.

Another important consideration when deciding among dividend-paying strategies is cost.

One dividend fund that is highly rated by Morningstar, the Vanguard High Dividend Yield ETF, is well diversified, which means investors won’t have a lot of exposure to one company, he said. What’s more, it’s also “really cheap,” with a low expense ratio of six basis points, or 0.06%. The expense ratio is a measure of how much investors pay annually to own a fund.

That Vanguard fund has historically provided a yield of about 1% to 1.5% more than what the broader U.S. market offers, which is “pretty reasonable,” according to Sotiroff.

While investors may not want to add that Vanguard fund to their portfolio, they can use it as a benchmark, he said.

“If you’re taking on higher yield than that Vanguard ETF, that’s a warning sign that you probably have exposure to incrementally more volatility and more risk, Sotiroff said.

Another fund highly rated by Morningstar is the Schwab U.S. Dividend Equity ETF, which has an expense ratio of 0.06% and has also provided 1% to 1.5% more than the market, according to Sotiroff.

Both the Vanguard and Schwab funds track an index, and therefore are passively managed.

Investors may alternatively opt for active funds, where managers are identifying companies’ likelihood to increase or cut their dividends.

“Those funds typically will come with a higher expense ratio,” Devinney said, “but you’re getting professional oversight to those risks.”