To Pick the Right Dividend Fund, Learn How They Work

Everything old is new again, and as investors creep back into equities, more and more are interested in income, or dividend-paying, stocks. As with many aspects of equity investing, you can get the same benefits and better diversification through mutual funds.

Dividend-paying mutual funds hold securities that pay dividends. The Internal Revenue Service requires that any income a fund gains through dividend-paying instruments in its portfolio must be passed on to investors. Those dividend-paying securities can be stocks, bonds, real estate investment trusts (REITs) or convertible bonds.

Sussing out the best dividend fund for your needs, though, requires a bit more digging.

"You really need to check the prospectus pretty carefully," warns Morningstar senior analyst Scott Cooley. "Just because a fund has 'dividend' in its name doesn't mean that you're going to get a lot of income."

Take Fidelity's FDGFXDividend Growth fund, please. If you're looking for income, you might think a fund named "Dividend Growth" would provide lots of it. But the yield on this fund is a paltry 0.83% -- less than half the S&P 500's 1.8% dividend yield. As far as income goes, you'd be better off in an S&P index fund.

A close reading of the prospectus explains why. The fund, according to the prospectus, "normally invests primarily in companies that pay a dividend or that it believes have the potential to pay dividends in the future." (You can find the prospectus on Fidelity's Web site.)

"Normally invests?" "Primarily?" "Have the potential to pay a dividend in the future?" That gives seasoned manager Charles Mangum quite a bit of leeway. In fact, it's hard to think of a stock that wouldn't fall into that category.

"Fidelity Dividend Growth is a terrific fund," Cooley says. "But not for income."

A Taxing Issue

If you're looking for income, you'll clearly want to find the highest-yielding fund with the lowest expenses. "With dividend yields so low these days, you really must home in on funds with low expenses," Cooley says. "A high-cost fund will eat up a lot of your dividend."