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. Investors in these funds can reinvest the dividends into more shares of the funds or use the dividends as an income stream.

Learn more about the advantages and disadvantages of this kind of mutual fund and some alternative investment options.

What Are Dividend Mutual Funds?

Dividend mutual funds hold stocks of publicly traded companies that pay regular cash dividends, often every fiscal quarter. Companies pay dividends to reward shareholders for their investment in the company.

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, which will then pass them along to its investors.

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

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—known as dividend yield—is calculated by dividing the annual dividend payout by the share price and multiplying by 100.

For example, let's say a stock pays a quarterly dividend of 60 cents a share and trades at $42 a share. Its annual dividend payout would be $2.40. When you divide that figure by $42 and multiply it by 100, you arrive at a dividend yield of 5.71%.

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

In August 2020, the dividend yield of the Standard & Poor's 500 was 1.71%, compared with a long-term average of 1.87%.

Other dividend mutual funds focus on stocks that are regularly 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 that have a history of increasing their dividends. For example, 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, with constantly changing prices throughout the trading day. (Mutual funds' prices are calculated after trading has ended for the day.)

ETFs are frequently designed 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 example, the iShares Core Dividend Growth ETF seeks to match the performance of the Morningstar US Dividend Growth Index.

Mutual funds and ETFs that seek to mimic an index's performance tend to have lower fees than funds that are actively managed, meaning the funds' managers choose their investments using some sort of screening process rather than passively buy them simply because they're in the benchmark index.

Dividend reinvestment plans (DRIPs) enable investors to buy additional shares or fractions of shares of a single company using their dividend payments. Some publicly traded companies enable you to invest in their stock directly, without using a broker. Alternatively, many online brokers will set up a DRIP for you free of charge.

Advantages and Disadvantages of Dividend Mutual Funds

Dividend mutual funds offer a steady stream of income and typically perform better in a bear (down) market than mutual funds that look for stocks with quickly rising share prices, known as growth stocks. In a bull (up) market, dividend funds will likely be outpaced by growth-focused mutual funds.

Ordinary dividends, the type you would receive by owning shares of a mutual fund, are taxed as ordinary income, rather than at the lower long-term capital gains tax rate. For that reason, you might consider investing in dividend mutual funds through an Individual Retirement Account (IRA), 401(k), or other retirement savings plan, where investments grow tax-deferred until withdrawals begin.

You must still report dividend income from mutual funds to the IRS and pay tax on it, even if you have elected to reinvest those dividends into the stock and don't take them in cash.

Determining a Mutual Fund's Dividend Yield

When researching dividend funds, consider looking at their dividend yields based on two different methods. The 30-day SEC yield reflects the dividends paid during the 30 days ended on the last day of the previous month, after deducting 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.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Key Takeaways

  • Dividend mutual funds are mutual funds that invest in stocks that pay dividends.
  • Investors in these funds can reinvest the dividends into more shares of the funds or use the dividends as an income stream.
  • Investors must generally pay taxes on dividends from mutual funds as ordinary income, even if the dividends are reinvested.