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 ( FDGFX) Dividend 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."

Think about it: The S&P 500 currently has a 1.8% dividend yield. The average equity fund carries a 1.4% expense ratio. It's simple subtraction, folks -- a fund with an average expense ratio and average yield could leave you with a 0.4% dividend payout.

Keep in mind, though, that high dividends mean higher taxes. Unlike capital gains, which have a lower rate structure, dividends are taxed at the investor's ordinary income tax rate. In other words, if you're in the 30% tax bracket, your dividends will be taxed at 30%.

The tax isn't withheld by the fund company; rather, the fund shop will send you a 1099-DIV in January, giving you a breakdown of the type of dividends and other distributions paid during the prior tax year. The Form 1099-DIV you get for tax year 2002 will include a dividend received in January 2003, as long as it was declared and was payable in the last quarter of 2002. You'll owe the tax on all dividends when you file; however, if you're collecting big dividend payouts throughout the year, you should consider making quarterly estimated tax payments to avoid an underpayment penalty come filing time. (The frequency of dividend payments depends on the fund; anywhere from once a month to once a year. Again, check the fund's prospectus to find out how often dividends are paid.)

Regardless of what type of dividend-paying securities the fund holds, investors can collect that income in one of two ways: They can either take the money and run (the mutual fund will send a check or directly deposit the amount of the dividend distribution) or they can reinvest the money in the fund (essentially using the dividends to purchase new shares). You'll make that decision when you first invest in the fund, but you can generally change your decision at any time.

Investors in it for the immediate income have already made the decision to collect the dividend payouts in cash, and will certainly owe income tax on the full amount. But investors willing to reinvest their dividends can avoid the tax if they keep the fund in a tax-advantaged account, such as a 401(k) or IRA. You'll still owe ordinary income tax on the amount you withdraw down the road, but won't pay tax annually on the dividend distributions.

NAV: Not an Appropriate Valuation

Sharp investors will notice that when dividends get reinvested in a fund, the shares that are purchased with the reinvested income are bought at a lower net asset value (NAV). That's because the act of paying out a dividend lowers NAV.

Look at it this way: If a fund has a $30 NAV before the distribution, then pays out $5 per share in dividends, the NAV drops to $25. If that $5 per share is reinvested, it will go to buy shares that have an NAV of $25. The total money invested in the fund, though, remains the same.

In this scenario, 100 shares at a $30 NAV amount to a $3,000 investment that pays out $500 in dividends. If you chose to reinvest those dividends, you'd essentially purchase 20 shares at $25 per share. So now you own 120 shares (your initial 100 shares plus the 20 the reinvested dividends bought), but your overall investment is still $3,000. And, of course, you'll owe tax on that $500.

But that's all just a mathematical exercise, Cooley says. "That's not an economic change at all and shouldn't factor into your decision as to whether or not to reinvest your dividends," he says. "NAVs aren't very helpful in evaluating investment options because they're so arbitrary. It's just a measure of the value of the fund's underlying holdings."

Know Your Fund

Lastly, when evaluating a dividend-paying fund, take a close look at where those dividends come from. While dividends from stocks, bonds, REITs and the like are all taxed the same way, how much they contribute to an income fund can significantly affect the rest of your portfolio.

For instance, if you've invested in a balanced fund looking for income, but the income comes largely from the bonds in the fund's portfolio, you may be better off investing in a bond fund for income and an equity fund for growth. If you're dependent on the income produced by a fund and are looking for a core holding, don't choose one that has the bulk of its income generated by REITs. (You don't want a significant percentage of your portfolio in such a tiny sliver of the market.)

And if you're using dividends as a way of justifying getting back into equities, make sure you find an equity fund that's paying a dividend that's higher than the S&P 500 after expenses, and that the dividends are actually from stocks.

Because while investor sentiment has had a retro-conservative bent, the 3.5% S&P yields of yore have not yet become new again.

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