How Dividend Funds Can Add Income, and Risk, to Your Portfolio

You can increase your investment income by buying a mutual or exchange-traded fund that owns dividend-paying stocks. Whether you should is a thornier question.

Dividends can be dependable — many companies increase theirs year after year — but the prices of the stocks to which they’re linked won’t necessarily be so steady. A fund or E.T.F. of dividend payers provides no guarantee against losses.

So far this year, the S&P Dividend Aristocrats Index — an index of dividend payers in the S&P 500 — lost 2.6 percent year-to-date through Sept. 30, even after factor in those dividends. The S&P 500 returned of 5.57 percent, including dividends.

What’s more, the pandemic has increased the risks that dividends will be cut as some companies’ earnings and cash flow diminish.

In contrast, the yield of the Vanguard High Dividend Yield E.T.F., which passively tracks the FTSE High Dividend Yield Index, was more than five times as high, at 3.59 percent. The fund has returned an annual average of 11 percent over the last decade as of Sept. 30.

Dividends can help plump a portfolio’s return. Long term, they’ve accounted for about 40 percent of the total return of the stocks in the S&P 500, said Mike Barclay, a co-manager of the Columbia Dividend Income Fund.

But investment professionals caution that focusing solely on dividend yield — a company’s annual dividend divided by its stock price — as a marker of a good investment can be a trap. Because of how yield is calculated — the ratio rises when a stock price falls — a sinking stock can result in a seemingly enticing yield.

“The companies with the highest yields can have very high levels of risk,” said Omar Aguilar, chief investment officer for passive equity and multi-asset strategies at Charles Schwab. “You can have an attractive dividend yield in a company about to go bankrupt.”

That quirk of yield is why the managers of active dividend funds and organizers of dividend E.T.F.s add quality screens to their stock selection.

Daniel Sotiroff, an analyst for Morningstar, said funds and E.T.F.s could impose an explicit screen, like investing only in companies that achieve a certain return on equity, or an implicit one, like allocating holdings according to market capitalization.

The latter approach means companies with the heftiest market caps will be the largest stakes in the fund, and those outfits “tend to be more stable and more profitable,” Mr. Sotiroff said.

Something to note if you’re considering a dividend fund is that the holdings can resemble those of value funds, said Ms. Ellison of Bingham, Osborn & Scarborough.

Value funds often invest in mature companies, and mature companies typically pay dividends. Managers of value funds seek stocks trading for less than their estimate of the worth based on a measure like the price-to-book or price-to-earnings ratio. This approach often leads them to out-of-favor companies or industries.

So buying a dividend fund or E.T.F. could mean increasing your exposure to that portion of the market, she said. So if you add a dividend fund to your holdings, you might want to substitute it for a value-oriented fund you already own.

Before venturing into any dividend fund or E.T.F., you should reassess your budget, said Jennifer Lane, owner of Compass Planning Associates in Boston.

Reducing your spending and the resulting drain on your investments is more prudent than trying to “juice what’s coming out of your portfolio” with a dividend fund, Ms. Lane said.

“You can’t just increase your dividend yield and spend more,” she said. If, as is typical, you’ve been relying on bonds for income, “you’re taking a lot more risk with dividend-paying stocks.”

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