New products for dividend strategists

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October 02, 2005|By CHARLES JAFFE

If a financial adviser ever asks: "How do you like your dividends?" fight the urge to answer with, "Regular and large, thank you."

Fight the smart remark because the way you want to pursue dividends is a real decision for fund investors these days.

It's not just that yields have improved over the past few years, it's that fund companies keep developing more and different products.

It's no longer a choice between fund families and plain-vanilla styles, it's a choice between pursuing dividends in a traditional mutual fund, a closed-end fund or an exchange-traded fund.

A decade ago, investors seeking dividend income simply chose between funds that used "growth and income," "equity-income" or "dividend growth" in their name. That worked fine, until the go-go market of the late 1990s, when many dividend-oriented funds earned so little in payouts that data trackers stopped taking the income seriously and came up with categories that described what a fund owned, rather than what management had promised it would do.

Investors loved the growth so much that they didn't mind that the bull market had trampled dividend yields.

The bear market, of course, reversed the trend, clawing at growth and reviving stodgy dividend-oriented strategies. The market beat-down also helped make dividend yields look just a bit more attractive.

Today, anyone who can't see the next wave of performance coming from an expansion of price/earnings ratios recognizes that dividends are a key element of generating a reasonable total return.

What's more, many big-name bull-market stocks have matured to where they pay dividends, winning over even more growth converts.

The heightened interest is smart, but the proliferation of choices can be confusing, particularly exchange-traded and closed-end funds, which average investors may not fully understand.

Exchange-traded funds are built and managed like an index fund - meaning they offer low-cost, passive management - but trade like a stock. Exchange-traded funds come in a wide variety of flavors, each pegged to an index with a slightly different tweak on the process.

Closed-end funds, meanwhile, are similar, though they more resemble an actively-managed fund that trades like a stock. What's more, closed-end funds frequently use leverage, which can goose the yield - thereby luring more investor interest - but also make the return more volatile.

For a dividend investor, deciding which route to take involves answering two key questions, one personal and one specific to the funds under consideration:

How much am I investing and over what time period? What is the cost of ownership?

If you plan to invest small amounts on a regular basis - or if you will move the money after a year or so - traditional funds get the nod, because the commissions paid to buy closed-end and exchange-traded funds bite the legs off of short-money deposits.

Buy-and-hold investors may find the lower costs of exchange-traded funds particularly attractive; dividend investors must be wary of costs, as small increases can maul an otherwise-sound strategy.

What is the fund trying to do, and how does it do it?

For a traditional fund, this boils down to knowing how the manager goes about picking stocks.

From there, it gets tricky.

"We've seen a proliferation of indexes being made for marketing purposes, so that someone can make an exchange-traded fund on it," says Gregg Brewer, director of mutual fund resources at Value Line. "While dividend stocks tend to ensure a safer ETF construction, that doesn't absolve an investor of doing homework and knowing what goes into the fund."

The names may sound the same - it's hard to tell the difference between "dividend achievers" and "strategic dividend achievers," for example - but the nuances are critical. You might be looking at a fund that buys only stocks with five years of increasing dividends, or one that buys only the 50 "dividend achievers" - based on Mergent's Dividend Achievers Handbook - with the highest growth rate over the past 10 years.

Notes Brewer: "Not every dividend strategy is equal. We see stocks with high dividends that wind up cutting the dividend or even going into bankruptcy. The indexes don't recognize that until it's too late; someone bothered by that might prefer an active manager in a regular mutual fund."

Likewise, an investor looking at the high yield of a closed-end fund wants to find out not only the investment style, but how leverage contributes to those returns. In a rising rate environment, a closed-end fund using leverage can wind up delivering a lot of volatility in the yield stream, which may not be what the investor bargained for.

"It's not as easy as buying something with `dividend' in the name, that's for sure," says Jeff Tjornehoj, an analyst for Lipper Inc. "It comes down to finding a strategy you believe in, and then finding the type of vehicle that can best deliver the results you expect from that strategy."

Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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