What Are Dividend Mutual Funds?

Definition & Examples of Dividend Mutual Funds

A man catching coins dripping from a tap, illustrating the concept of dividend payments
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Dividend mutual funds are mutual funds that invest in stocks that pay dividends. If you invest in these funds, you can reinvest the dividends into more shares. Or, you can use the money as an income stream.

Learn more about the pros and cons of this kind of mutual fund. Also, find out about other investment options.

What Are Dividend Mutual Funds?

Dividend mutual funds hold stocks of publicly traded companies that pay regular cash dividends. This is often done every fiscal quarter. The payouts are meant to reward shareholders for their investment.

How Do Dividend Mutual Funds Work?

If you own stocks of dividend-paying companies through a mutual fund, the dividends will be paid to the fund. It will then pass them along to its investors.

Dividend mutual funds tend to own shares of established companies. They often have a long history of paying dividends. These stocks are often referred to as blue-chip stocks; this used to be a high-value color of poker chips.

Types of Dividend Mutual Funds

Some dividend mutual funds focus on stocks that pay high dividends that represent a large percentage of their stock price. That percentage is known as dividend yield. Here's how you can find it. First, divide the annual payout by the share price. Then, multiply by 100.

For instance, let's say a stock pays a dividend of 60 cents a share each quarter. It trades at $42 a share. That means its annual dividend payout would be $2.40. When you divide that figure by $42 and multiply it by 100, you arrive at the dividend yield: 5.71%.

The names of these funds might include phrases like "Dividend Yield" or "High Dividend."

Note

In May 2021, the dividend yield of the Standard & Poor's 500 was 1.37%. This is compared to the long-term average of 1.87%.

Other dividend mutual funds focus on stocks that are increasing the amounts of their dividends. These funds might include phrases like "Dividend Growth" or "Dividend Appreciation" in their names.

A dividend mutual fund may invest according to an index that tracks companies that have high dividend yields. Or, those that have a history of increasing their dividends. For instance, the Vanguard High Dividend Yield Index Fund (Admiral Shares) seeks to mimic the return of the FTSE High Dividend Yield Index.

Alternatives to Dividend Mutual Funds

Exchange-traded funds (ETFs) are like mutual funds that are traded like stocks. Their prices change often throughout the trading day. This is in contrast to mutual funds: their prices are calculated after trading has ended for the day.

ETFs are meant to reproduce the performance of an index of stocks. And like dividend mutual funds, some of them aim to mimic an index of stocks known for paying high or increasing dividends. For instance, the iShares Core Dividend Growth ETF seeks to match the performance of the Morningstar US Dividend Growth Index.

Note

Mutual funds and ETFs that seek to mimic an index's performance tend to have lower fees than funds that are actively managed. That means the funds' managers choose their investments using some sort of screening process. This is in contrast to passive buying simply because they're in the benchmark index.

Dividend reinvestment plans (DRIPs) allow you to buy more shares using your dividends. Or, you can even buy fractions of a share. Some companies let you invest in their stock directly without using a broker. And many online brokers will set up a DRIP for you free of charge.

What Are the Pros and Cons of Dividend Mutual Funds?

Dividend mutual funds offer a steady stream of income. They also often perform better in a bear (down) market than mutual funds that look for stocks with quickly rising share prices. These are known as growth stocks.

In a bull (up) market, dividend funds will likely be outpaced by growth-focused mutual funds.

Ordinary dividends are the type you would receive by owning shares of a mutual fund. These are taxed as ordinary income. They aren't taxed at the lower long-term capital gains tax rate. For that reason, you might want to invest in dividend mutual funds through a retirement savings plan. In that case, investments grow tax-deferred until withdrawals begin.

Important

You must still report dividend income from mutual funds to the IRS; you also must pay taxes on it. This is true even if you choose to reinvest those dividends into the stock and don't take them in cash.

How to Find a Mutual Fund's Dividend Yield

When looking into dividend funds, assess their yields based on two methods. The 30-day SEC yield reflects the dividends paid during the 30 days that ended on the last day of the last month; this is after you deduct the fund's expenses.

A mutual fund's trailing-12-month (TTM) yield refers to the percentage of income the fund returned to investors during the past 12 months. In the case of a stock mutual fund, income consists of dividend payments.

Key Takeaways

  • Dividend mutual funds are mutual funds that invest in stocks that pay dividends.
  • You can then reinvest the dividends into more shares of the funds. Or, you can use the money as an income stream.
  • You must pay taxes on dividends from these funds as ordinary income, in most cases. This is true even if the dividends are reinvested.