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Sooner or later, the markets always punish investors who do the right thing for the wrong reason.
Some investors in dividend-oriented stock funds might end up learning that lesson the hard way.
So far this year, $9 billion has gone into mutual funds and exchange-traded funds that focus on U.S. stocks that pay stable, high or rising dividends, estimates EPFR Global, which tracks where investors are moving their money.
All other U.S. stock funds combined have had a net outflow of $7.3 billion.
Many of the investors joining the dividend stampede appear to be motivated by the low interest rates mandated by the Federal Reserve, which have led to a yield famine among traditional income investments like bonds, certificates of deposit and money-market funds.
Others might just be chasing past performance. The 100 highest-yielding stocks in the Standard & Poor's 500-stock index outperformed the overall market by an average of eight percentage points last year, according to Birinyi Associates.
Think twice before you jump on the bandwagon. While dividend-oriented funds are a perfectly legitimate way to invest in stocks, you shouldn't mistake them for bonds.
Nor, popular belief to the contrary, are they much safer than the stock market as a whole. And they could suddenly go from being tax-friendly to painfully taxable.
When you buy a Treasury, you collect interest and get your money back (not counting inflation) when the bond matures. When you buy a dividend-paying stock, you collect a quarterly payment -- but that certainly doesn't mean the stock price will be stable.
In the fourth quarter of 2008, the S&P 500 fell 21.9%; dividend-oriented mutual funds lost 20.2%, according to investment researcher Morningstar (MORN) . In other words, the average dividend fund fell nearly as much as the overall stock market. Bonds, meanwhile, performed beautifully: Over the same period, the Barclays Capital U.S. Treasury index returned 8.75%.
And from the stock market's peak in the fourth quarter of 2007 through its bottom in the first quarter of 2009, the Dow Jones U.S. Select Dividend index lost 53.8%, versus a 50.2% loss for the S&P 500, according to Fran Kinniry, an investment strategist at Vanguard Group.
In the long run, dividend-paying stocks are slightly less risky -- and more rewarding -- than the equity market as a whole. In the short run, however, they can expose you to the risk of being in the wrong place at the wrong time.
In 2007, 29% of the S&P 500's dividend income came from banks and other financial stocks, according to Howard Silverblatt, senior index analyst at Standard & Poor's.
That didn't end well. Many banks that had been paying steady income to shareholders suspended their dividends -- or even went bust. Their investors suffered.
Today, financials account for only 13% of the S&P's dividends, with consumer staples (15%) and technology (14%) contributing the biggest share. Apple (AAPL)'s recent declaration of a dividend might prod more tech companies into distributing cash to shareholders. Some dividend funds could thus end up concentrated in technology stocks, much as they once were in financials, says Steve Condon, investment director at Truepoint, a financial-advisory firm in Cincinnati.
Another point: Since 2003, dividends have generally been taxed at just 15%, much lower than most bonds, whose interest payments are taxed at ordinary-income rates. Unless Congress and the White House take action, the dividend rate will leap to 43.4% next year for investors in the top federal tax bracket -- the same rate that would apply to most bonds. You can avoid this problem in a tax-sheltered 401(k) or individual retirement account.
Robert Gordon, a tax expert at Twenty-First Securities in New York, thinks "there's a good possibility" that politicians can work out a deal to keep dividends taxed at today's lower rate, but there isn't any assurance of that.
The right reason to own one of these funds, says Daniel Peris, author of "The Strategic Dividend Investor" and co-manager of the Federated Strategic Value Dividend fund, is that stocks with growing cash distributions tend to be solid businesses that earn greater returns in the long run than stocks as a whole.
"I would like to think that every client who's buying a fund is buying for the right reason, but that would be naive," he says. "I acknowledge that some people, based on last year's strong returns, may be chasing past performance."
Any memory more than three years old is ancient history on Wall Street. But investors on Main Street should hark back to 2008. That year, many dividend funds provided at least 3% in income -- but their average total return was minus-35%.
There aren't any easy ways to get income when the bond market is this stingy. Expecting the stock market to be generous certainly isn't one of them.
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