Best Dividend Mutual Funds for 2016

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Disappointed with the income generated by your investment portfolio? You’re not alone. Through mid-September, investors socked away nearly $10.2 billion into dividend-focused funds, hoping to earn higher yields from their investment portfolios.

But where many funds promise high yields, not all live up to their mission. High yield mutual funds frequently charge exorbitant fees that leave little for their income-seeking investors. Others offer high dividends, but at the cost of any hope of capital appreciation.

Here are 3 dividend mutual funds that check all the boxes for yield, low fees, and investment strategies that won’t leave you disappointed.

Source: Vanguard, T. Rowe Price

Warning!

When it comes to generating income from mutual funds, one of the most important things to consider is a fund’s expense ratio, or what investors pay to own a fund expressed as a percentage of their investments. Expense ratios are always important, but they are particularly important if your goal is to generate income from dividend mutual funds. 

Expenses are taken out of yields that are paid to investors. Thus, if a fund holds a stock portfolio that yields 3%, and the fund has an expense ratio of 1%, then the fund’s yield to investors will be just 2%. You’d lose a third of your would-be income to management fees by investing in this fund. That’s enormous!

Most of the funds on this list are managed by Vanguard. That isn’t an accident -- and no, I’m not a Vanguard employee, nor did I only look at Vanguard funds when making this list. Vanguard simply has some of the best and least expensive funds on the market, which means that more of the income will go into your pocket. So, without further ado, let’s talk about why these dividend mutual funds are some of the best on the market today.

Vanguard High Dividend Yield Index Fund

This fund is as simple as it gets. It is an index fund, meaning that it simply tracks an index of stocks. That index is the FTSE High Dividend Yield Index.

The index starts with a universe that includes virtually every stock on the market. It then throws out companies that do not pay a dividend, as well as real estate investment trusts, which pay high dividends that are tax inefficient and whose shares have less potential for capital appreciation.

After ranking all stocks by yield, the index adds stocks one by one, starting with the highest-yielding stocks until it has a portfolio of stocks whose market values represent half of its list of dividend-paying stocks. It then invests in each company based on its relative size, so that large companies make up a bigger portion of the index than smaller companies.

The net result is that the index is very diversified, and holds more than 400 stocks. It is also very much a “blue chip” fund, in that mega cap companies make up a substantial portion of its assets.

The fund’s performance has been spectacular since its inception. In the last 5 years, it has roughly tracked the performance of the S&P 500, an index which tracks large cap stocks listed on U.S. exchanges. Most impressively, more of its returns come out in the form of yield. The fund currently yields about 3.1%, much higher than the 2.1% yield of the S&P 500.

Vanguard Equity-Income Fund

Though it is known for its index funds, Vanguard also offers a line-up of low-cost funds that are actively managed by professional portfolio managers and analysts. The Vanguard Equity-Income Fund is one such fund.

This fund isn’t all that different from the High Dividend Yield Index Fund discussed above. In fact, managers of the Equity-Income fund benchmark their performance to the same FTSE index that the High Dividend Yield fund tracks. However, the goal of this fund is to beat the index's performance rather than matching it.

Wellington Management is responsible for managing about two-thirds of the fund’s assets, and seeks out stocks with above-average dividend yields and below-average valuations. It also looks for companies that can grow their dividends over time. The remainder of the fund’s assets are managed by a Vanguard team, who employ a quantitative approach to “systematically identify stocks” that are “more likely to exhibit long term-term outperformance.” All in all, the fund held 218 stocks at the time of writing, roughly half that of the Vanguard High Dividend Yield Index fund.

Over the last 5 years for which there is data for both funds, the actively-managed Vanguard-Equity Income Fund underperformed the aforementioned index fund by a small margin of about 0.16% per year, on average. This is partly due to the fact that it, unlike the index fund, has a small amount of cash on hand (about 2% of assets) as well as foreign holdings that the index fund doesn’t have.

Relative to other equity income funds, though, it’s no contest. The fund disclosed a 10-year average annual return of about 7.4% in its 2015 annual report, crushing the 5.6% return of the average equity income fund. Low fees have helped it tremendously, as its annual expense ratio of just 0.29% is much lower than the 1.22% expense ratio of its peers.

T. Rowe Price Dividend Growth

This fund is one of the rare funds that has outperformed despite a higher expense ratio. The fund primarily invests in stocks that have a strong record of paying dividends, or which offer the potential for dividend growth over time. It states that it looks for stocks that can grow their dividends at a rate faster than inflation, while also having the capacity to deliver capital appreciation from rising stock prices over time. 

T. Rowe Price takes a much more concentrated approach to investing, holding about 100 stocks at any given time, substantially fewer holdings than Vanguard’s two funds listed above. Theoretically, managers who invest in fewer companies have a greater chance to beat their benchmark and peers. The opposite is also true; concentrated investors have a greater chance of underperformance.

The downside of the fund’s higher expense ratio and focus on dividend growth is that its current yield is much lower than other dividend-focused funds. The fund offered a yield of about 1.2%, well below the 2.1% yield of the S&P 500. If the fund is successful in the pursuit of good dividend growth stocks, however, the dividends it pays to investors should grow faster than that of the market and rival funds.