Your Funds: Dividend plays feel better than ever

Conventional investment wisdom for at least the past half-century has been simple: Use stocks for growth and bonds for income. That has been conventional wisdom in large part because the yield on the 10-year U.S. Treasury note has been higher than the dividend payout on the Standard & Poor's 500 index for most people's investment lifetime.

But in late August, for the first time in 53 years, the S&P yielded more — about 2.25 percent — than the 10-year Treasury (2.1 percent), and that has some investors looking more than ever to use dividend-paying stocks to deliver income.

The bullish view would be that companies are raising dividends because they have too much cash to know how to put it all to work; the bearish view would suggest that they're scared to put the cash they have to work in these economic conditions, so they're paying it out. Bulls and bears can argue about the whys and wherefores, but both sides are at least intrigued by the idea of cashing in on the trend.

The flip-flop in which investment type provides higher yields simply is the latest impetus for investors to re-evaluate dividend payouts, but pundits and analysts have been suggesting that long-term investors consider generating a greater chunk of their income from stocks for a while now. No one should confuse yield with safety; higher yields can help to minimize market losses, but they won't be much comfort in a downdraft.

For average investors, making a dividend play in mutual funds is trickier than simply picking solid stocks and hanging on for the quarterly payouts. For starters, few investors pay much attention to the yield on a fund, especially because distributions are often considered more of a tax headache than an actual benefit of ownership.

Moreover, most funds pay distributions just once per year; an investor who doesn't consciously choose a fund that makes more regular distributions won't have the same feeling as someone who buys stocks planning to collect dividends every quarter. And because a fund's holdings can change on a moment's notice, the yield an investor sees when looking at recent statistics or in a fund's paperwork could be different than what they actually get.

"While some yields on individual blue chips make buying them a small-brainer — if not a no-brainer — buying a blue-chip fund and assuming the yield will be similar would be a mistake," said Jim Lowell, editor of the Fidelity Investor newsletter.

While that would argue for fund investors tilting toward individual quality stocks, rather than funds, Lowell noted, "There are a handful of uniquely well-crafted, positioned and managed funds that offer reasonable yield based on their holdings' underlying dividend distributions."

Finding those funds isn't always easy. The search starts with costs. If dividend distributions are a big part of the reason to buy, then costs are particularly important because the dividend pool is the first place funds go to cover their expense ratios, before anything flows to shareholders.

Next, an investor has to decide where they are willing to go to get dividends. The big yields today are coming from certain industries, notably financial services, real estate investment trusts, energy and utilities. Many investors get queasy thinking about those businesses in this economy and would prefer to stay away. That's easy to do when you're picking individual stocks but a lot tougher with funds.

Likewise, closed-end funds and some ETFs have compelling yields, but they may use enough leverage to move them from the realm of "stable, income-producing investment" into something more volatile and edgy.

"There are a lot of ways to get dividend yield in funds, but most people will want to go into something that has low volatility, that isn't leveraged, and that isn't in industries they're uncomfortable with," said Michael Falk of Michael S. Falk Asset Consulting in Chicago. "If all they do is look at a yield number, they are setting themselves up for a possible problem."

In looking for dividend-paying funds and ETFs, experts suggested looking for yields that are at the level of the S&P or better. They noted that value-oriented plays may make the most sense, if only because income investors who pursue a dividend strategy typically need to be extra careful about overpaying to get yield.