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Finding Stock Funds with Big Yields

And why you'd want to own a fund that pays dividends.

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Let's talk dividends.

It would be a stretch, certainly, to say that dividend-paying stocks have caught fire. But they've definitely warmed up since the late 1990s, when they were routinely dismissed as a quaint relic of the old economy.

The Case for Dividends
So, what has changed? First and foremost, the bear market served painful notice that supercharged growth forecasts--which abounded during the runup--aren't always realized. Through that experience, many chastened investors have come to appreciate the dependability of slower, steadier businesses--the kind that typically pay dividends. Second, in May 2003, Congress slashed the tax rate on dividends to 15%. That burnished the luster of dividend-paying stocks, which had formerly been taxed at more-punitive, ordinary income levels. Finally, there's safety in numbers: More and more public companies have been paying out dividends. The decision from  Microsoft (MSFT) to pay regular dividends, plus its monster one-time $3 special dividend in November 2004, was probably the most noteworthy, but it was hardly unique.

To be sure, more-advantageous tax-treatment or growing popularity does not an attractive investment make. But there are a number of enduring reasons why dividend-geared mutual funds might be worth your while. For instance, say you're getting ready to retire and want to establish an income stream that's less susceptible to the ravages of inflation than a bond fund's. Or maybe you believe, as some do, that regular dividend payments are a reflection of a firm's stability and profit growth going forward. Finally, with some experts predicting low-to-mid-single digit equity returns going forward, you might find that an income-oriented stock fund--which offers the added certainty of predictable dividend payments--is preferable to an approach that's dependent on potentially scarce capital appreciation.

Finding Dividend-Paying Winners
Unfortunately, finding a dividend-focused equity fund using Morningstar's data isn't as simple as combing through an "equity income" category for the best option. That said, with a little work you can narrow down the field. That's where Morningstar's Premium Fund Screener comes in. Here's a quick rundown of a screen that should help you separate the wheat from the chaff:

1. "Fund Category = Domestic Stock (ex-Specialty)"
Because some funds that specialize in certain market segments, such as real-estate, energy, and utilities, tend to invest in stocks that pay hefty dividends, they're likely to pay fat yields. However, for your purposes, a diversified offering is the best long-term fit. As such, this step will serve to exclude those specialty funds from your screen.

2. "Trailing 12-Month Yield >= 2.01%"
Defining a suitably high yield is subjective, but to find a dividend-geared stock fund, you have to draw a line in the sand somewhere. When screening for yield using the  Premium Fund Screener, an information window pops up to inform you that the top quartile of Domestic (Ex-Specialty) Stock funds have yields ranging between 2.01% and 26.89%. So, for this search, we'll go for funds that sport yields that rank in the top quartile of all funds--those at or above 2.01%.

3. "Distinct Portfolio = Yes"
This will ensure that you only see one share class per fund, making it easier to scan the list.

4. "% Bond <= 5%"
As noted earlier, bonds are more vulnerable to inflation. Thus, if you're looking for a way to capture a stable income stream without getting nicked by rising prices, you'll want funds that almost exclusively rely on stocks. Hence this tweak, which ensures that a fund isn't boosting its yield by holding a slug of bonds. (You'll find the "% bond" criterion under "Portfolio/Composition" in the screener.)

5. "Morningstar Risk not = High"
This search assumes that investors are looking for a fairly stable, easy-to-hold mutual fund. This line screens out any funds that generate a high Morningstar Risk score. Note that this is an optional line in this screen, but it fits the thesis that drove its creation.

6. "Closed to New Investment = No"
Because you're trying to create a buying list, screening out funds that are closed to new investments is a necessary final step.

Click here to run this screen for yourself.

The Results
As of March 24, 2005, the screen described above yielded 19 funds.

It's worth noting that quite a few of the offerings that make it through this screen include the words "dividend" or "equity income" in their names. Those are some of the first funds you might want to research further. You'll want to weed out any expensive funds, since expense ratios are paid out of a fund's dividend yield.  You'll also want to see how income relates to a fund's strategy. The best place to find that information is probably in a Morningstar Analyst Report, if one's available. Each analysis imparts lots of other pertinent information about a fund.

Below are three funds from the list that we're particularly fond of:

Vanguard Equity-Income (VEIPX)
The name pretty clearly announces the fund's strategy: investing in firms that pay hefty dividends. Here they are chiefly big, well-known firms. As is often true with Vanguard offerings, the fund greatly benefits from its cheap costs. Its 0.32% expense ratio is a fraction of the large-value category norm. That's especially handy for a dividend-focused fund, because a fund's expenses come out of its income first. The fund also boasts a sensible three-sleeve strategy, in which a contrarian stock-picker (Wellington Management's Jack Ryan), a traditional value manager (John A. Levin Co.'s Jack Murphy), and Vanguard's in-house Quantitative Equity Group all take part.

ParnassusEquity Income (PRBLX)
This fund is likely to have two-pronged appeal for some investors: It's not only a dividend-focused fund, but it is also managed per a socially conscious mandate. As such, while manager Todd Ahlsten targets high-yielding stocks, he sidesteps firms like alcohol, tobacco, and weapons manufacturers. That's a nice feature given that tobacco firms often pay hefty dividends, which unsurprisingly puts them on the radar screens of many income-minded investors. Yield-hungry, socially-minded investors don't have to compromise here, however.

Franklin Equity Income (FISEX)
Among the broker-sold equity income funds that come through this screen, we like this one. Its 2.2% yield is pretty substantial--partially because it has a fairly low 0.93% expense ratio. True, the fund hasn't done very well when dividend-paying stocks are out of favor. Yet the fund's very low volatility over the long haul makes it easy to buy and hold. That smooth ride comes partially because the fund has a distinctly mega-cap flavor, and those firms don't blow around in the market's winds as much as smaller firms. Given that mega-caps have lagged for some time, the fund has lagged for the past few years. But the fund has done very well over the long haul. Given that mega-caps look ready to rebound at any time and the fact that dividends appear to be coming into favor, this could be a particularly opportune time to own this fund.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.