How to Find the Best High Dividend Mutual Funds

There are good mutual funds and bad mutual funds. How do you tell which is which for your needs? For many investors, good mutual funds are mutual funds that return high amounts of dividends, which are regular payments made from the profits gained by the mutual fund.

High dividend mutual funds are great assets to have for any portfolio because they give you a good stream of income to supplement your capital gains from stock appreciation or bond maturity. Finding the best high dividend mutual funds involves identifying what kind of return you want and then determining the yield, minus expenses, that you’ll receive.

Here, I’ll walk you through the basics of high-dividend mutual funds and selecting ones for your portfolio – complete with a few recommendations based on performance and philosophy.

Dividends and Mutual Funds

Dividends – or payments from profits – are one of the main ways mutual funds generate returns for their investors. As the assets held by the mutual fund perform well, they pay dividends or interest to the mutual fund. This is a contrast from the capital appreciation method of mutual fund returns in which the mutual fund itself grows in net asset value (NAV) as the assets it holds grow in value.

Dividends generally offer less of a return than capital appreciation, but are less risky, as well. All dividends are distributed at least once annually; many are distributed quarterly or semi-annually. In order to receive the dividend distribution, you have to own shares on or before what is called the record day, which is announced in advance by the mutual fund.

You have to pay taxes on all proceeds from dividends just as you do for capital appreciation gains; taxes are determined by how long the fund (not the fund investor) has held the assets. Any assets held for at least a year are taxed either at 15% for investors who are in a 25% tax bracket or higher, or 5% for investors with a tax bracket below 25%. Short-term gains are taxed at ordinary income levels for investors.

Dividends are good for investors who want solid returns without having to deal with the risk of a mutual fund and its assets declining in value.

Finding High Dividend Mutual Funds

There are many theories and strategies behind finding the right mutual fund and locating one that pays high dividends. Most high-dividend mutual funds focus on companies that have strong cash flows, low debt and liabilities, and large market capitalizations. For funds that invest in bonds, the chief metric is the credit rating of the government that issued the bond.

The safest route is either to go with government bond funds or with mutual funds that vastly prefer large firms that pay regular dividends and have a track record of doing so. One noted example of these types of funds is the Vanguard Dividend Growth Fund (VDIGX), which has produced an 18% average return for the past three years and hones in on large-cap companies with strong cash flows – companies like Occidental Petroleum (OXY), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and PepsiCo (PEP). Another example is the Columbia Dividend Income Fund (LBSAX), which delivered a 6.77% return in 2011 and is based on companies with reliable cash flows like IBM (IBM), AT&T (T), and Pfizer (PFE).

For returns that are a bit more aggressive and deliver even higher dividends, you can find mutual funds that dabble in the junk bonds market. Junk bonds are bonds that have credit ratings of below BBB-. These non-investment grade bonds have a historical default rate of anywhere from 31% to 42%, but degenerate the highest returns because of their risk.

One mutual fund that plays extensively in the junk bond market is the Fidelity High Income Fund (SPHIX), which currently supplies a yield of 6.8%, with a YTD yield of 7.71 for 2012. It also has a pretty low expense of just 0.76%, and has gained over 150% over the past decade, with an annualized return of 10.07%.

What is the Best Sector for Mutual Funds?

You can also look for high dividend mutual funds by sector. While analysts all have different opinions on which sector is the best one for mutual funds, many point to energy mutual funds as being the most consistent provider of high dividends in the market.

This is because the energy sector produces something that is always in demand – energy in the form of gasoline, petrochemicals, and electricity. While oil and gas are sensitive to supply and demand and economic realities, they are still hot commodities. That is the reason why Exxon Mobil is the world’s largest company by revenue. It is the second-largest company in the world by market capitalization. In fact, out of the top ten companies in market cap, three are in the energy sector. (Exxon Mobil, by the way, current produces a 2.69% dividend all by itself.)

One solid choice for an energy mutual fund is the Vanguard Energy Inv (VGENX), which has heavy exposure in energy stocks both in the United States and abroad. These holdings include companies like Exxon Mobil, Chevron Corp (CVX), Occidental Petroleum, BP (BP ADR), and Royal Dutch Shell (RDS.A ADR).

You can also look to the utilities sector for high-dividend mutual funds because utilities are remarkably consistent. People constantly need power. While demand dips seasonally, it is always strong over a long period of time – even during recessions. For this reason, many utilities produce steady dividends and continue to do so.

So far in 2012, Fidelity Telecom and Utilities (FIUIX) has produced the highest dividend for long-term utility funds, at 7.10%. For short-term funds, the winner so far is Franklin Utilities Adv (FRUAX), at 6.42%.

Think about what kind of return you want, how much risk you are willing to take on, and what strategy you want to use. High dividend mutual funds are out there and are great resources for income generation for any portfolio.

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