Why Stock Dividend Funds Keep Growing

US News

Equity-income fund inflows hit a record last week in another sign that investors are increasingly looking to dividend-paying stocks for yield and relying less on the low payouts they get from bonds as they try to protect against volatile stock market swings. The strategy has proven its value over the past year, and some see it continuing.

"Investors use it as kind of a safety play," says Tom Roseen, Lipper's head of research. "It's been going on for a while. People were starting to put less into equity income when stocks were really rising quickly. Now they're coming back to it."

Why the shift? The "safety" component of such funds is that they represent a way to spread the risk of any single company cutting its dividend, since investors can collect yield on a wider number of stocks. Cash-rich corporations have been increasing dividends at a high rate--both ExxonMobil and Apple announced the two largest-ever payouts in history for any single company during one week in April, with Apple on top and ExxonMobil pennies behind. One factor pushing dividend increases is the growing influence of corporate activists like Carl Icahn and David Einhorn, who invest in companies and push such increases. Microsoft was the latest to be targeted for more payouts.

[See Meet the New 'White Hat' Activists: Not Just Raiders Anymore]

"It's been quite a run for dividend stocks," says Fred Dickson, chief investment strategist for D.A. Davidson & Co. "There's been some pullback recently, but the dividend stocks will probably continue in favor as long as rates stay low for bonds."

When stocks were surging, investors were moving more cash into growth stocks. But there have been regular reminders about how volatile the market can be. Wall Street had its worst day since last November on April 15, with a decline of more than 2 percent. Just a week later, the market plunged on a Twitter-feed hoax claiming a bombing had taken place at the White House. It triggered a 145-point fall in the Dow industrials.

A way to prepare for rate hikes. Investors are also buying equity-income funds as a way to prepare for rising interest rates in anticipation that the Federal Reserve may let rates rise in the next year or two. That would cause bond prices, which are inverse to yields, to plummet. Stock dividends are better bets in that scenario because they can be increased, says Roseen.

Dickson says the potential for gains in individual stocks that pay dividends adds to the attraction. A diversified fund doesn't have as much potential for pure returns unaided by payouts. But even if markets underperform, for dividend investors, "what happens with the Dow does not really happen as long as you get your dividend," he says.

[Dividend Drama: Will Your Company Increase, Cut or Stay Put When Earnings Are Announced?]

Dickson also notes that there has been a big shift in how investors view the role of dividend stocks and their function in the income component of a diversified portfolio. That could mean stocks might be a larger portion of some portfolios, even among retirees. For example, if a retired person is 40 percent in equity and 60 percent in bonds, it's prudent to shift one-third of that income into equity dividends, he says. That would put the overall equity portion at 60 percent stocks when the income is shifted from bonds to dividend stocks or funds.

Record week comes with an asterisk, but is still a clear sign of demand. Equity-income funds experienced inflows in 40 of the past 52 weeks, according to Lipper. Still, a big piece of the record $1.44 billion jump in equity income is from one major fund family, Federated Capital Appreciation Fund, which merged assets into the Federated Equity Income Fund. That accounted for $834 million of the increase in equity-income totals. But Roseen says it was more than simply a "reclassification" because it showed investors' demand for equity income. "They are focusing their effort on a winning category," he says.

In stock trading, sectors that pay relatively high dividends are outperforming the Standard & Poor's 500 index as investors pursue them for their mix of income and capital appreciation. Telecoms and cable companies have been strong over the past year among investors seeking both. Verizon and Comcast have been among the favorites, with both showing gains of over 30 percent in value over the past year, more than twice the growth of the S&P 500. Verizon's dividend yield is 3.9 percent and Comcast's is 1.9 percent.

[See 10 'Digital Utilities' That Could Pay You Dividends]

For those who want to invest in funds, Dickson says there are a number that track the 50 highest-yielding constituents of the S&P Composite 1500 index that have increased dividends every year for at least 25 consecutive years. One of them, the SPDR S&P Dividend ETF, has a total return of 14 percent so far this year and a 52-week return of 20 percent. Its three-year average return is 13.9 percent. Consumer-staple companies like Johnson & Johnson and Kimberly Clark are among the components.

"Those companies are managed in a way that assures steady cash flow and earnings year after year, and they focus on ways to increase the dividend," Dickson says. "That's not a bad way to manage any company. It means they pay a dividend regularly, and usually it means that not only will they go up in value but the stock's value will rise, too."

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