Stock Funds Yield Surprisingly Strong Dividends

(Dow Jones) One of the mutual fund world's dirty little secrets has been that "growth-and-income" and "equity-income" funds provided shareholders with virtually no income.

The "income" these funds were supposedly pursuing came in the form of dividends, but dividend yields were low during the Internet bubble days, so fund managers tilted towards growth and ignored the mandate for income. Then, during the ensuing bear market, managers weren't willing to settle for dividend plays where the payout was too paltry to keep the fund north of the break-even line.

As a result, by the time money-market funds were paying next to nothing and investors were flooding bond funds with cash despite historic lows in interest rates, funds that had long been ridiculed as "growth-but-no-income" were out of the picture as dividend plays on the market.

Yet as the market has made dividend investing popular again, fund managers have put the income back into these traditionally income-oriented asset classes. The question is whether income-seeking investors are paying attention.

Dialing For Dividends

Many investment gurus have been preaching the benefits of dividend-paying stocks. It's not just that an investor can buy a stock and get a regular payout while they wait to see if the investment premise succeeds, it's that investors have flooded bond funds with money in an effort to find a safe haven that squeaks out better-than-money-market returns.

The fear with all of that money going into bonds has been how those investors will react when interest rates rise and the bond funds stumble. When rates rise, bond prices fall, and bond funds--hich must value their portfolio as if they were selling everything at the end of the day-take a hit. Experts worry that the action ultimately could be so volatile that it will terrify the people who sought a safe haven, especially if they pulled the bulk of their money out of stocks to make the bond play.

Dividend-paying stocks, meanwhile, come with all of the stock-market risk, but they are being hyped as bargains right now because stock prices have not been bloated.

According to investment researcher Morningstar Inc., the trailing 12-month yield for the average equity fund is 2.28%. That's roughly the same rate an investor could get on the average five-year certificate of deposit, but there's no lock-up of the money in the fund. The typical growth-and-income fund has a 12-month yield of 2.01%, and the yield on most Standard & Poor's 500 index funds and ETFs is a shade under 2%. Average dividend yield in those categories have been below 1% for the better part of a decade.

"A lot of people would jump at the chance to buy a bond fund or a short-term CD that they believe is paying a steady, trustworthy 2%," said Pat Goodall, editor of the No-Load Portfolios newsletter. "Now they have some attractive dividend-paying funds that they could use to generate income, but they just don't think of their stock funds that way."

Income Comes Into Play

Indeed, a key difference between a fund with income as its primary focus and one where the label "and income" proves that income is a secondary concern is how dividends are distributed to fund shareholders. An income-oriented investor with a bond fund can get monthly distributions, whereas most equity-income funds gather dividends and make a distribution to shareholders once or twice a year.

Indeed, stock funds collect dividends throughout the year, along with capital gains--profits from the trading of shares-and pay out to shareholders in a lump. It's tough for investors to receive that payment--which reflects capital gains or losses beyond the dividend income-and have a picture of the fund's yield. Searching for 12-month yield is something most investors never do. (Call your fund company and ask for it.)

If you need the fund as a source of current income, having regular payments is important. Some investors shy from funds in favor of a portfolio of individual dividend-paying stocks, which they can assemble in a way that smooths out their cash flow. You can also get regular dividend income from closed-end mutual funds.

But if you don't need that monthly source of cash, industry watchers say that investors can get dividends from funds that should have been providing it all along.

"You are looking at some good funds like Oakmark Equity & Income (OAKBX) and Vanguard Wellesley (VWINX) where the yields are higher and there probably is more focus on dividends than there has been in years or decades," Goodall noted. "I don't think most people pay much attention to the dividend yield on their funds, but if you are looking for something conservative that you feel like you can hold for a long time in these conditions, you should at least find out if your fund is at least thinking about income."