If you've read this site for awhile, you know that dividends can be a great way to generate passive income, and mutual funds can be a good option for new investors who don't want to handle the decision of selecting individual stocks for their portfolio. The next logical step for a lot of people is to consider dividend mutual funds. These are funds that specifically focus on holding a portfolio of stocks that pay dividends. Some dividend mutual funds focus on high yielding stocks, while others specialize in stocks with the fastest growing dividends. Some dividend mutual funds focus solely on companies headquartered in the United States, while others prefer to collect dividends from around the world in multiple currencies.
How can a person go about finding the best dividend mutual funds for his or her portfolio? There are two easy places to start.
1. Many of the Best Dividend Mutual Funds Mimic the S&P 500 Dividend Aristocrats Index
The S&P 500 stock market index contains most of the largest corporations in the United States. Within this list of 500 companies, Standard and Poor's creates a sub-list called the dividend aristocrats. To make this special list, a company must have not only paid a dividend, but increased their dividend payout on a per share basis for 25 consecutive years or longer. That's an extraordinarily difficult task to achieve. So difficult, in fact, that only 51 companies at this moment, in August of 2014, qualify. The list of dividend aristocrats includes businesses such as Clorox, Coca-Cola, Colgate-Palmolive, McDonald's, Wal-Mart, McCormick, Sherwin-Williams, Walgreen, AT&T, Abbott Laboratories, and Exxon Mobil.
There are several index funds that follow the dividend aristocrats or some derivation of the index. The key is to find the one that offers the lowest mutual fund expense ratio, among other considerations. Sometimes, these dividend funds come in the form a classic, traditional mutual fund, whereas other times, they are structured as an exchange traded fund, also known as an ETF.
To provide a real world illustration: One of the most popular dividend mutual funds is called the SPDR S&P Dividend ETF, which mimics the S&P High Yield Dividend Aristocrats Index. It trades under ticker symbol SDY and costs only 0.35% in gross expenses per annum, which is a mere fraction of what is ordinarily charged by actively managed mutual funds. At the moment, it offers a dividend yield of 2.22%.
2. Research Equity Income Funds at Morningstar Because Many of the Best Dividend Mutual Funds Use This Phrasing to Describe Their Investment Strategy
As you learned in "What is an equity fund?", Wall Street uses the term "equity fund" to refer to mutual funds that focus on stocks, as opposed to other asset classes such as bonds or real estate. By slapping "income" on the end, it denotes that the goal is to invest in cash-generating (read: dividend paying) stocks. It's one of those things that gets taken for granted by those who work in the financial industry but isn't immediately apparent to a newcomer who has never so much bought a share of anything in his or her life.
Morningstar, the world's best known mutual fund rating agency, has a lot of information on equity index funds. They will allow you to look up their past performance, expense ratio, management history, portfolio holdings, and much more. Many of the big name discount brokerage firms offer free Morningstar research to their clients.
One of the (historically) best dividend mutual funds trading under the equity income fund terminology is the Vanguard Equity Income Fund, which is "designed to provide investors with an above-average level of current income while offering exposure to the stock market". It achieves this by "typically invest[ing] in companies that are dedicated to consistently paying dividends". It has two different classes of shares. The first, the Investor Class, has an expense ratio of 0.30% and requires a minimum investment of $3,000. The second, the Admiral Class, has an expense ratio of 0.21% and requires a minimum investment of $50,000. They both yield approximately 2.6% at the moment.
Remember that Even the Best Dividend Mutual Fund Will Perform Poorly from Time to Time
The stock market is remarkable in that it generally does very well over long periods of time, while appearing completely unpredictable for periods of 5 years or less. It's entirely possible you might invest in a dividend mutual fund only to watch it drop 50% the next day. Stranger things have happened in history.
However, if you pay a good price for your stake (one trick to determine valuation if you aren't financially sophisticated is to compare the dividend yield or earnings yield to Treasury bond yields), keep your on-going costs low, take advantage of deferred taxes, reinvest your dividends, and dollar cost average for at least 25 years, your odds of doing well, based on historical evidence going back more than a century, are very high. There has never been a single period throughout time when the return for someone following such a prescription was negative. Even better, the returns have always beat inflation. There is no guarantee that will always remain true but as long as people are buying Clorox bleach or brushing their teeth with Crest toothpaste, owners should be collecting the profits.
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