Dividend Mutual Funds Definition, Advantages, and Tips

Financial figures and bar graphs

Roy Scott/Getty Images

Mutual funds are a popular method of investing for people that are looking for capital growth and less risk. There is another type of mutual fund, however; the type that pays dividends. Dividend mutual funds are funds that are invested in stocks and then traded on an exchange.

These funds collect dividends from the stock issuers, and then payout the dividends to the fund's investors. Dividend mutual funds play an important role in many investor's portfolios, acting as rubber floors that help absorb the impact of a downward trend.

If you've been considering looking for more ways to diversify your portfolio, you might consider investing in a dividend-paying mutual fund. It helps to know how these funds work, understand the risks, and weigh their advantages and disadvantages.

Types of Dividend Mutual Funds

Dividend mutual funds options are divided into two categories—you can reinvest the dividends in the fund for growth, or simply take the dividends. Dividend mutual funds, as the name implies, pay dividends to the investors. Dividend growth funds take a different approach; the dividends are reinvested into the fund, creating growth by growing the invested capital.

As the growth fund gets larger, more dividends are reinvested and the fund begins a slow exponential growth cycle.

Dividend Mutual Funds Definition and Advantages

Dividend mutual funds are mutual funds that primarily invest in companies that pay dividends, which are a percentage of profits that companies award to shareholders.

Dividends can be received as a source of income, or they can be used to buy more shares of the mutual fund. In most cases, because of their income-generating nature, dividend mutual funds are best-suited for retired investors or those wanting a less work-intensive lifestyle.

Dividend mutual funds also tend to be less aggressive (less risky) than other types of funds, such as growth stock mutual funds.

Some investors also like to use mutual funds that pay dividends in economic environments where bond mutual funds are not as attractive—such as economic conditions when interest rates are low (bonds have lower yields in this case, but higher prices). This leads investors to switch from bonds to stocks—in this case, to dividend-paying mutual funds.

Disadvantages and Tips for Using Dividend Funds

While there are benefits to dividend mutual funds, there are also disadvantages. Investors should be cautious of dividend mutual funds because dividends are taxed as ordinary income. For this reason, some investors may consider buying dividend mutual funds in an Individual Retirement Account (IRA) or 401(k), where earnings grow tax-deferred until withdrawals begin.

An easy way to invest in dividend-paying stocks with mutual funds is to use Index Funds or Exchange Traded Funds (ETFs). These mutual funds usually hold large-capacity stocks (stocks from large, well-performing companies) that pay dividends. In the case of index funds, they often hold the stocks within an index, such as the S&P 500, that pay the highest dividends.

Some dividend funds also buy and hold stocks of companies that have track records of increasing their dividends. This way, the investor has the potential to receive dividends but also increase them over time.

SEC Yield and TTM

When researching dividend funds, you can get a good idea of past and future dividend payouts by analyzing the fund's yield. The 30-day SEC yield—a figure based on a formula required by the Securities and Exchange Commission—reflects the dividends and interest earned during the period, after the deduction of the fund's expenses.

The 30-Day SEC Yield of a mutual fund refers to a calculation that is based on the 30-day period ending on the last day of the previous month.

A mutual fund's trailing 12-month yield, or TTM, refers to the percentage of income the fund portfolio returned to investors over the past 12 months.

Therefore, the 30-Day SEC Yield gives you an idea of the current yield and what you might expect in the near future. The TTM yield gives you an average payout from the past, which may or may not repeat over the next 12 months.

Article Table of Contents Skip to section