Most investors buy a stock hoping that it appreciates over a long period of time. But sometimes, investors want to generate immediate cash flow from their investments. Fixed income products, such as bonds, are popular for these purposes, but dividend funds can be an attractive alternative.
The easiest way to buy dividend stocks is to purchase a dividend fund that holds a diversified portfolio of stocks. That way, a single company that cuts their dividend or goes bankrupt doesn’t significantly affect the overall cash flow that you receive. You can still have access to a safe and consistent income.
Let’s take a look at the nuances of investing in dividend funds and how to find the best option for your portfolio.
Why Invest in Dividend Funds?
Dividend funds are exchange-traded funds (ETFs) or mutual funds that invest in companies that pay dividends—profits that companies share with their stakeholders. They are typically used as an alternative for bond funds or other fixed income investments to generate a predictable cash flow.
Bond funds are the most popular investment vehicle for retirement asset allocations, but dividend funds may be an attractive alternative when interest rates are low and economic conditions are favorable. In these cases, bond fund yields may be low and dividend stocks may be safe. Smart investors shift to an income producing portfolio when they retire and move to the distribution phase from the growth phase. This will help maximize the portfolio’s withdrawal capabilities and lengthen the amount of time a portfolio can support themselves in retirement.
There are many good reasons to invest in a dividend fund:
- The upside potential may be higher than a bond fund since stock prices tend to appreciate over time.
- The dividend may be higher than the amount that you could earn from bond funds or other fixed income investments.
- There’s less interest rate risk compared to bond funds with prices that are more sensitive to those changes.
But there are also several downsides to consider:
- Dividend stocks are more volatile than bond funds in most cases, which could translate to greater risk.
- Bondholders have seniority over stockholders when a company goes out of business, making them safer investments.
- Dividend stocks may decline in value if economic growth slows down, whereas bonds could hold their value better.
You should carefully consider these factors before adding dividend funds to your portfolio and/or speak with a financial advisor.
Choose a Dividend Strategy
There are many different dividend funds available and each of them has its own benefits and drawbacks. For example, real estate investment trusts (REITs) pay higher dividends than blue-chip stocks, but interest rate movements will have a much greater impact on their performance.
The most popular types of dividend funds include:
- Multi-Asset Funds hold a variety of different dividend-producing assets to reach certain goals. For example, a high income fund will maximize yield and a dividend aristocrat fund will focus on generating the most stable income.
- Preferred Stock Funds invest in preferred stock rather than common stock, which tends to pay a higher dividend. Preferred stock also has a greater liquidity preference than common stock, but remains below bonds on the ladder.
- Real Estate Funds invest in mortgages and other real estate investments that generate a steady income. REITs are an especially popular real estate fund because they avoid double taxation and provide the highest level of income.
- Utility Funds invest in utility stocks that offer a combination of safety and yield. Since they’re regulated by the government, they pay very stable dividends and act more like a bond than other blue-chip equities.
- Energy Funds invest in energy projects that generate a steady level of production and income. For example, MLPs enable investors to profit from the production of oil or natural gas coming out of one or more projects.
The right dividend investment strategy for your portfolio depends on several factors, including your existing portfolio, risk tolerance, income requirements, and economic conditions.
Analyze the Risk and Return
The next step after choosing a dividend strategy is to analyze the risk and return for the investment, which should mesh well with your overall portfolio. For example, a retirement investor may want to avoid high-yield dividend funds since the underlying stocks can be riskier than utility or real estate funds that may be more stable.
The best way to measure return is by looking at the 30-day SEC yield, which reflects the dividends and interest earned during the period after deducting the fund’s expenses. In other words, the figure represents what you actually earn as an investor and provides a more accurate measure than the raw yield.
There are many ways to measure risk, but the beta coefficient is the most common. This metric measures the variable of the fund versus the S&P 500. Lower readings mean that the fund is less volatile and higher readings mean that it’s more volatile. You can also compare a fund to bond funds.
It’s important to ensure that the returns match your return requirements, such as your cash flow requirements during retirement. In addition, you should ensure that the beta coefficient, or risk, isn’t too much to assume given your existing asset and retirement goals.
The Bottom Line
Dividend funds may be a good choice for some investors that require regular cash flow, but it’s important to carefully consider the different strategies available and analyze the risk and return to make sure it meshes with your portfolio and goals before jumping into a fund.
Investors that are hesitant to buy dividend funds, but still want greater income potential than fixed income investments, may also want to consider covered call writing strategies. Using the Snider Method, or a similar system, you can write covered calls against a long stock portfolio to generate regular cash flow that can be used throughout retirement.