May 28, 2004 — Advisers wishing to capitalize on the recently enacted dividend tax cut may be in for some unanticipated headaches. Since Congress reduced the maximum tax on stock dividends from 38.6% to 15% last year, a spate of new mutual funds have been launched to take advantage of the lower rates. But their investment strategies are so diverse and obscure it’s easy to get confused. “You really have to lift up the rock with these funds and see what’s underneath,” says Ronald Rutherford, a financial planner in Naples, FL. “You have to look at their holdings, their turnover ratio and their track records. If you don’t, you might wind up with a fund that is inappropriate for your portfolio.”
Even within the same fund family there can be significant strategic differences. Consider the case of the Vanguard Equity Income (VEIPX) and Vanguard Dividend Growth(VDIGX) funds. Equity Income is a value fund, which invests in beaten up stocks with above average dividend yields. Newcomer Vanguard Dividend Growth also buys dividend stocks, but rather than looking for a high current payout, manager Minerva Butler wants stocks that will increase their dividends in the future. “These are high quality stocks with solid prospects for revenue and earnings growth, which should translate into above average dividend growth,” she says. So growth stocks like Microsoft Corp (MSFT), which currently has a lower than average 0.7% dividend yield, and Intl Bus. Machines (IBM) land in her portfolio. As a result of this strategy, Dividend Growth’s current 1.7% yield is lower than Equity Income’s 2.5%.
Fidelity’s dividend funds are even more diverse. There are currently four – Fidelity Dividend Growth (FDGFX), Fidelity Equity Income (FEQIX), Fidelity Equity Income II (FEQTX), and newcomer Fidelity Strategic Dividend & Income. All but the last are similar to their Vanguard counterparts except that Fidelity’s dividend growth fund is more growth oriented than Vanguard’s, paying less attention to current payouts. Meanwhile, Strategic Dividend & Income is a completely different animal altogether, combining dividend paying stocks with convertible bonds, preferred stocks and Real Estate Investment Trusts (REITs), the income from which is taxed as ordinary income. That could make using the fund for taxable accounts confusing to advisers, as they will never be sure what portion of the fund’s income will be taxed at the lower rate till the payout arrives.
Some advisers have reservations about investing for dividends when the average stock in the S&P 500 currently yields only 1.5%. “Both dividend growth and equity income strategies are valid styles of investing,” says adviser Lewis Altfest of L.J. Altfest & Co in New York. “But to make a compelling case for them I’d like to see yields of at least 4%, which are not accentuated by buying bonds or preferred stocks.” That said, Altfest does use such funds in his clients’ portfolios, but treats them more as traditional value and growth stock funds. Currently, he holds positions in T Rowe Price Equity Income Fund (PRFDX), which has a value slant, but is considering switching to a fund such as Washington Mutual Investors Fund/A (AWSHX), which, he says, is more growth oriented. “In today’s market, cheap value stocks have been bid up some,” he says. “So a good tactical strategy is to buy a dividend growth fund.”
Although value stocks tend to yield more than growth, a fund’s yield is a poor indicator of its style. For instance, FAM Equity Income Fund (FAMEX) has a definite value bias, but manager Paul Hogan finds his bargains among small companies, which have low yields. “We feel we can make a lot more on the appreciation side than on the dividend side,” says Hogan. Small companies need to retain their cash flow to grow their businesses, not pay it all out to shareholders, so it is better to look at other indicators of their value than yield. “We capture the dividend as part of our overall cash flow analysis,” Hogan says.
Trading strategies can also goose fund yields in ways that have nothing to do with stock valuations. Manager Jill Evans of the Alpine Dynamic Dividend Fund (ADVDX), which launched last September, invests one third of her assets with a “dividend capture” strategy. “We buy mature companies with large dividend payouts but little capital appreciation potential right before their about to pay their dividends,” she says. “We hold them for 61 days-the minimum amount required for a dividend to be taxed at the 15% rate-then rotate out of these stocks into other companies about to pay dividends.” Such rapid rotations allow Evans to collect six annual dividends from that portion of her portfolio instead of four, amplifying the income produced by the fund. As a result, Evans says, “we’re going to give investors a yield well over 6% this year.”
Such aggressive trading can be costly, though. “Look at the turnover in a portfolio like that,” says planner Rutherford “You’ll still have high trading costs even if you don’t have tax costs there.” Rutherford prefers to look at the total return of a dividend fund rather than its yield. “You can’t always depend on the yields of companies,” he says. “Sometimes they’re in trouble when they’re paying high dividends. We’re more interested in sustainable growth in dividends and capital appreciation.”