Posts Tagged ‘dividend funds’

As far as dividend funds go, the Invesco Diversified Dividend Fund (LCEIX) has managed to secure itself some high returns, making it a natural short-list favorite among investors who are looking for dividend mutual funds as part of their investment strategy. What makes this Invesco mutual fund such an easy choice also has a lot to do with its consistent returns, consistently beating its peers (overall) when it comes to risk-adjusted returns.

Interestingly enough, this mutual fund has managed to earn above average returns over the past 5 years. Currently, it holds 90% domestic equities, itself a difficult achievement given the volatility the markets have shown on a year-to-date basis, particularly with how this fund invest: primarily, it adopts a large cap, value/blend approach. Kudos for that.

Unlike other funds in its category, the Invesco Diversified Dividend fund has stepped back from IT and media plays, clearly taking an underweight position in those areas and instead beefing up in the Industrial Materials, Consumer Goods and Financial Services segments. This makes a bit of sense when you look at the underlying assets. Its biggest earners have been Fifth Third Bancorp (26% YTD return), SunTrust Banks (24% YTD return), Eaton Corporation (23%), Marriott Corporation (22%) and Emerson Electric (20%). These are all top 25 holdings and clearly strong performers.

At the Mutual Fund Site, our biggest concern with the investment style is the fund’s heavy investment in manufacturing type companies. While these have clearly provided some good returns, the uncertainty surrounding the manufacturing sector and its reliance on consumer spending could have terrible implications for these securities, particularly these days when you hear about consumers spending less thanks to the “slow recovery.” What people should be worried about is the company’s ability to continue paying dividends even in the face of slowing demand.

What we like to see here is its marginally below weight holdings of financial services firms. This has been an extremely popular segment and has quite possibly become overbought, resulting in longer term cost problems for some funds. But even if we are right about high price of entry here combined with a lack of profits thanks to slower than expected consumer spending, this fund’s financial services choices are brilliant, having opted for strong financial services firms that pay decent dividends and have strong fundamentals backing them.

Even the non-financial firms in their top holdings — looking at Emerson Electric, Eaton and Marriott for example — are also strategic and relatively worry free choices. All three companies have seen year-over-year quarterly results improve, they continue to have strong balance sheets and they are among the leaders in their industries and, as evidenced by their returns, have been worthwhile investments for the fund.

As for dividend funds, we continue to favor the Vanguard Dividend Fund given its smart investment style and consistency. But with an entry level of $1,000, this Invesco comes with an entry level that is 1/3 of the Vanguard fund, making it more accessible to more investors. And with the performance record that it enjoys, it will obviously appeal to a lot of mutual fund investors as one of the easiest dividend funds one can own.

The Mutual Fund Site has done this before: gone out on a limb and made a fairly wild claim that if you do X, you will enjoy Y. As far as the variables, X is normally what mutual fund to buy and Y is usually enjoying some kind of returns. Well, to get more specific, we claimed at the beginning of the year that if you bought a particular Janus High Yield Fund, you would enjoy steady returns in 2010. We were right. If fixed income is not your cup of tea, we said the same about the Ivy Small Cap Value fund. Again, we were right.

Today, the story is much of the same. Only those variable have changed (although we are not suggesting you drop those two investments). But for investors who want to see less volatility than that the Ivy Small Cap and for those who are really starting to get nervous about how interest rates might impact the Janus High Yield Fund, then why not do what makes the most sense?

Invest in a Dividend Growth Fund ahead of the economic recovery

Here’s the thing. We know there is an economic recovery on the horizon. The yield curve tells us as much. Even the most bearish investors realize that a recovery will take place. It may not happen today (although it very well might) and it may take several years before equities that enjoying the wild growth they have seen in the past, but it will happen.

And until/when it does, then the Vanguard Dividend Growth (VDIGX) is one of your safest best. As a dividend fund, this Vanguard has been recognized by Morningstar as a top performer for its Overall, 3-year and 5-year performance, earning a coveted 5-star rating for those period.

But what really impresses us is that this dividend fund achieved maximum returns with nearly no risk at all. The dividend yield alone is a decent 2.32% and while several of its slimly-held 49 securities have performed poorly (take ExxonMobile, for example, a top 10 holding contributing -12.3% on a YTD basis), the balance of the securities continue to perform the point that this fund is set to gain just as soon as the markets get a whiff of that recovery.

Among the fund’s top holdings are Johnson and Johnson, ADP, UPS, Mcdonald’s, Wells Fargo, ConocoPhillips, Wal-Mart… all companies that continued to produce during the toughest economic moments.

These strong holdings of course are the fund’s biggest downfall; everyone knows that most investments that performed well were not these larger, well-capitalized companies. Instead, smaller cap stocks tore up the markets in 2009 and into 2010. Quality is not so much an issue as the speculative opportunities for growth that the small cap value play offered.

At this point, the fund remains in the red to the tune of roughly 3%. This makes it somewhat uncertain for some investors. However, it leads its peers by a hair and its track record sure says a lot about how well Donald Killbride of Wellington Partners has done with this fund. With a low turnover, the Mutual Fund Site recommends holding this fund for the long-term (3-5 years minimum) and adding it as a core holding to your portfolio; with a $3,000 minimum investment to get in, this is not a specialty fund.

Ask nearly every professional mutual fund manager what they do for a living and their response might surprise you. While normal people like the rest of the world see (many) mutual funds as fine examples of investment strategy, security picking and so on, the professionals who pull the trigger on trades actually see their roles in the investment management quite differently. In fact, they see their jobs more as risk managers than investment managers.

Their view makes perfect sense, of course. They are risk managers, no question about that. Take the AIM Diversified Dividend Fund, a 5-star fund as measured by Morningstar. That fund has $1.5 Billion worth of other people’s money… you bet they are risk managers! If Meggan Walsh, who has been managing this big fund since 2003 thought otherwise, the fund would not have made the investments it has made, it would not have achieved the high returns it has enjoyed and it would not have done so with average or below average risk.

Risk is the investor’s greatest consideration when throwing money at a security.

Consider that — average or below average risk while achieving high returns. This is key because returns can be quite easy if one is willing to take the risks. And that risk is loss of capital. Which sounds simple in many ways, but how many of us felt that taking on risk was a reasonable thing to do before the market correction of 2007, 2008 (ouch) and the first quarter of 2009?

Even though higher risk is frequently synonymous with higher returns, we often forget that higher risk often means higher probability for loss. And those losses are very real when they happen.

So the recommendation is really to shift our thinking from high risk = high rewards to one where we aim to achieve above-average returns by taking on less than average risk for those returns. The idea is to achieve more than the risk levels dictate. That means earning 10% when the Beta or assumed risk suggests we should only enjoy returns of 7% or 8%.

To illustrate, consider high-risk derivatives. While it might be nice to achieve 5% returns, if you could achieve these returns with guaranteed and insured term deposits, why bother with the high risk derivatives? It makes little sense, right? But if we could achieve 10% returns with those same term deposits, why not give up the excitement of the market? (Of course, this rarely happens, so we have no choice but to accept that higher risk).

Mutual funds help us achieve above average returns while enjoying below average risk. This is because mutual funds so something many of us fail to do on our own — they diversify. (They also measure risk better than we do because they have the staff to analyze financial statements, perform site visits, call up management and so forth). Ultimately, diversification saves these mutual funds when risk rears its ugly head more than anything else — after all, no amount of analysis and over-management can eliminate market risk; but diversification can surely reduce all other risks.

While individual investors might opt for a dozen or so investments, mutual funds like the AIM fund quoted here, hold over 75.  And with 78% of those assets as large cap or giant cap, they really are achieving better returns for less risk. And this is important especially when markets sour. Again, referring to the AIM fund, its performance has outpaced the S&P 500 for its YTD, 1-year, 3-year and 5-year periods. The performance speaks for itself.

And this is just one fund. Most properly managed funds will evaluate risks and trade accordingly. The result? Those total returns outpace the broader market and, just as equally, other funds in its category. For investors this means less losses in market downturns and greater returns when the markets turn around.

Just yesterday (February 14, 2010) the Mutual Fund Site announced its top small cap pick for 2010 — the Ivy Small Cap Value fund. In that long-winded post, we outlined various reasons why this small cap fund is a no brainer, why all of the ducks are lined up and its sights for gains are clear for this year. With the mildly improving interest in housing thanks to the gradually improving employment figures, a lot of regional banks like those held by the Ivy Small Cap Value fund stand to profit. What emphasizes this fact is that a lot of regional banks are better positioned when financial service reform will start to take shape.

Okay, this entry is not intended to regurgitate what we wrote in our release or in the post. With that in mind, we will examine one area that makes this small cap mutual fund one of the most intelligent mutual funds available to the investors with the right risk tolerance, time horizon and investment objectives. Why? Because its dividend yield!

We have spoken at length about dividend funds and the importance of dividends in helping boost earnings withing a mutual fund. In fact, we have gone so far as to suggest that dividends can make the difference between what people perceive as a smart investor and an unlucky one. Where the Ivy Small Cap Value fund makes such a great investment is in its dividend yield of 2.8%.

Remember, value funds’ primary area of focus for returns lies in the abilities of the mutual fund manager to pick up underpriced assets. If the fund manager wanted dividends to prop up returns, he or she would be managing a dividend fund. With Ivy, the point is clearly in the “value” its assets offer. This can be supported by the relative low average P/E for the fund of just 15.7. This tells us that the underlying securities are clearly undervalued.

So where do these dividends come from, exactly?

We mentioned yesterday that three of its Top 5 holdings are Wintrust, IBERIABANK and East West Bancorp. Their dividend yields are 0.6%, 2.5% and 0.3% respectively (as of Friday’s closing price). Now, IBERIABANK’s dividend is clearly the highest, but still falls short of the fund’s average dividend yield. And with just 77 securities in its portfolio, obviously some of the other financials are paying much higher dividend yields. Look at First Niagara Financial Group as an example; they pay 4.1%.

And all of these financial services companies are strong. They have solid and/or growing equity positions, they are profitable and, well, they pay decent dividends.

Let’s look at some of the bigger financial services options out there.

• Citigroup. Its dividend yield is 0%.
• Wells Fargo. Its dividend yield is 0.7%
• Goldman Sachs. Its dividend yiled is 0.9%

The point here is that so many value investors will throw money at the big guns. Those are the large financial services firms listed here, two of which are terrific “buys” according to the well respected analysts surveyed by Thompson/First Call as well as other prolific stock analysts. But what about First Niagara, IBERIABANK and a handful of other in Ivy’s small cap fund?

These are what people call as investment “Secrets.” They are those dividends that people chase (within reason of course; no sense in buying a bankrupt stock even if it pays a 10% dividend!). The dividends that people wish they knew about.

Is there risk in a small cap fund? Yes. Is there risk in the Ivy Small Cap Value fund? Yes (although Morningstar lists its risk as low compared to its peer group). But when you have a small cap fund that pays 2.8% in average dividends, the fact remains that dividends are not only an important part of smart investment management, but are an essential contributor to a mutual fund’s returns.

Mutual Funds are an interesting beast when you get into dividend funds. Some investors feel that dividend funds are where to invest any and all amounts of money and this argument actually has some merit. After all, dividend-paying securities usually generate enough cash to make dividend payments and they are typically the largest stocks by market capitalization (though not always). But talk is cheap when it comes to investment management, so we came prepared to back up our argument for why dividend funds can take you from zero to hero in one year.

Some of the sweetest statistics around involve securities. Where mutual funds become a lot more attractive is in their management levels — you do not have to find the best dividend-paying securities because the fund manager will do all of that work for you.

The S&P 500 is a great starting point. Of thee 500 securities included in the S&P 500, 73.6% of them (or 368 of 500) pay dividends. That means that an Index fund alone will pay dividends within the fund.While this is not impressive on its own, consider that dividend funds will choose the best companies and, most likely, the best companies of those that pay highest-paying dividends.

The average dividend yield on the S&P 500 as of February 8, 2009 was 1.89%. Understandably, this is not a rate that would knock most people off their feet. The US Treasury Bond term that comes closest to such a yield is the 3-year Treasury. Go to 5 years and your Treasury Bond yield exceeds the average dividend yield on the S&P 500. Why does this matter? Well, nobody has ever been considered a hero by investing in 5-year Treasury Bonds and turning an “easy” hands-off rate of return that would make many people jealous (that being said, people who do pull off great returns investing this way are actually called genius or lucky, or probably both).

That average yield of 1.89% takes into account all S&P 500 securities, including the 132 that do no pay any dividends at all. The average dividend for those 368 securities that do pay dividends is actually 2.43%, better than the 5-year Treasury Bond rate of 2.31%. Now, 2.43% is a little better (much better than banks and investment houses will pay on a 1-year term deposit), but definitely not enough to make someone an investment “hero.”

So, how can one improve their dividend yield to something that would not only put even the 30-year Treasury Bond investor to shame, but would make all of your friends at the golf club blush with envy? Take a peek at the top-25 highest dividend companies where the average yield is actually 6.89%. Now we’re talking; that alone represents a more than one third of the 19% that the S&P 500 returned in all of 2009 (Jan-Dec).

Now, however, comes the question of “quality.” What do these top-25 dividend-paying securities have to offer? Are they on the brink of reducing their dividends? What do analysts think?

Well, Frontier Communications which has the most aggressive dividend yield is rated as a Hold on average by the 10 analysts surveyed by Thompson/First Call. On a year-over-year basis, Frontier is seeing growth in their quarterly earnings, although this is definitely nowhere near substantial enough to base an investment decision. What mutual funds hold Frontier outside of an Index fund? Reaves, DNP, and MFS are the largest holders.

Some of the other companies in this Top 25 include Verizon, Leggett & Platt, Eli Lilly and Integrys Energy. Obviously, these are all companies that most people have heard of, but whether they are worthy of hard-earned investment dollars is a decision often best-left to the mutual fund managers who have the resources to study every little detail of these securities.

So, in answering how dividend funds can take an average investor from zero to hero, consider that as of February 2010, these Top 25 securities in the S&P 500 are paying an average yield of 6.89%. That does not take into account any growth, which many of these shares have already given back. Next step is to short-list the dividend funds that actually perform and exceed standard performance levels.

Despite all of the press out there that suggests that high yield investments are not where investors want to invest, there is a small group of professionals (including those of us at the Mutual Fund Site) that believe that these mutual funds are indeed still favorably priced. But not everyone is well suited for high yield investments. Those people will typically chasing growth rather than income. For those investors, dividend funds might be where to invest.

The interesting thing with dividend funds is that they provide income, much like a bond fund or high yield investment would pay income (the difference is dividend income versus interest income). With dividend mutual funds, investors can expect yields around the 5% range, some higher and some lower depending on the fund you are considering.

But the kicker with dividend funds is that investors should be more focused on the growth prospects of the securities held within that mutual fund. The Vanguard High Dividend Yield Investment as an example pays roughly 5% but is also invested in large-cap value stocks. While that yield is certainly nice, the underlying holdings have an average P/E ratio of 15.7. This suggests that the future gains will come more from the growth of those underlying securities than the dividends themselves.

While we have not completed our full analysis of the Vanguard High Dividend Yield investment, this fund illustrates the difference between high yield funds and dividend funds. That key difference? Where the future returns are most likely to come from.

As for risk, the investor will need to determine the proper level of risk he or she is willing to assume. This will ultimately determine the type of fund (growth versus value, large cap versus mid- or small-cap, etc.) and can help create something of a short-list for the investor. In essence, however, dividend funds are similar to high yield bond funds. But the bottom line is that bonds will pay income and dividend funds pay dividends as a bonus; the key is in the long-term growth prospects.

So when it comes down to it, dividend funds are not the new high yield investments. They are merely different beasts co-existing for different investors with different needs.

We talk a lot about the importance of building an all-inclusive portfolio in our Asset Allocation section. As far as Investment Management is concerned, you really need to incorporate all of the different asset classes in order to maintain a properly diversified portfolio that is sure to perform over the long-term and provide steady income and growth.

One of the key contributors to a steadily performing and growing portfolio is a dividend component. As far as dividend funds are concerned, there are several benefits to the investor. Not only can dividend funds boost earnings through dividend income and long-term growth prospects, but they can also safeguard the portfolio from dramatic and drastic losses. This is achieved based on the following:

• Dividend payouts not only provide income, but in most cases dividends that are paid out within mutual funds are reinvested within the fund, allowing the fund holder to purchase additional units and passively grow their holdings. To further illustrate the power of dividend reinvestment, consider that if an average Dividend Yield is 2.5% for a fictional dividend fund, then reaching outperforming the market will involve less risk. For a total return of 10%, the dividend fund need only achieve 7.5% growth in order to keep up with the market. This ultimately allows the fund manager to invest in less risky assets.
• Dividend Funds will naturally target stronger companies that involve less risk. As noted above, there is considerable comfort to be gained by the investor and fund manager when investing in dividend-paying securities. However, by virtue of the fact that dividend funds will target and hold securities that are paying dividends, there is some financial security backing those companies. If the dividend were cut or eliminated entirely, such companies would likely be dropped, pushing the security price down (look at GE’s stock price when it slashed its dividend in 2009). Therefore, dividend paying companies work hard to maintain their dividend payouts. As such, they do their best to maintain specific equity and capital, thereby making them stronger companies financially… at least in theory.
• Dividend Funds provide safeguards to your portfolio since they are normally built with stronger companies, meaning their Beta is normally lower than the broader market. Since these markets are hyper-sensitive to potential failures and perceived credit risks, holding stronger companies (or companies that appear stronger by virtue of maintained dividend payments) the funds that hold them are more likely to experience steadier growth rates and muted losses. So, while more speculative funds may be more prone to wild upward and downward swings that more-closely follow the market’s ups and downs, dividend funds will follow a less exciting (both positive and negative) path.

In the past, we have outlined the potential high yield investments, or specific bond funds, for 2010. While the Mutual Fund Site stands behind its top mutual fund pick for 2010, such investments are never a one-stop-shop for investors. Additional diversification is needed to flesh out the asset allocation model and regardless of the investor profile, dividend funds can fill the needs of almost every investor. For the conservative investor, dividend funds can provide that necessary diversification by allowing conservative exposure to the equity asset class; dividend funds provide steady income. For more aggressive investors, dividend funds provide additional diversification within the equity class, allowing for a proper long-term investment management strategy.

Regardless of your specific portfolio needs, make sure you incorporate dividend funds in your portfolio.