Some investors had a big portion of their portfolios stashed in money market funds earning a little or no value. To get more yield, and maybe some appreciation, they might want to move some money to an equity-income fund. This choice worried me. Did they know dividend-paying stocks aren't money market or bond substitutes; that they could lose money; and that the strong trailing returns of funds didn't presage future results? More importantly did they know what they would own?
Getting Technical
A lot of income-seeking investors find themselves in this predicament, and not all of them can answer those questions in the affirmative, especially the last one. Indeed, while investors seemed to have a handle on the risks they were contemplating taking, they were surprised to learn the income-oriented stock funds in recent years have edged into areas that historically haven't been associated with dividends.
For instance, domestic-equity funds with above-S&P 500 yields and records of at least 10 years currently have more money, on average, in technology stocks and less in financials and utilities companies than they did a decade ago. That's a reflection of how dividend-focused managers' opportunity set has changed over the years. It also shows how yield-seeking investors can't take the traditional definition of equity-income stocks for granted.
Say "dividend-paying stock" and many investors are likely to think of utilities, telecommunications, consumer goods, and financial companies. That's still true, but more tech stocks to whom dividends were anathema at the turn of the century are distributing cash to investors now. At the end of April 2012, the information technology sector was the second-biggest contributor to the S&P 500 Index's yield after consumer-staples stocks, up from fifth place in 2011 according to S&P indexes. A new dividend from the benchmark's largest holding, Apple (AAPL), accounts for much of that move, but several other tech companies in the S&P, such as Oracle(ORCL), Cisco Systems (CSCO), and Analog Devices (ADI), have initiated or increased payouts in recent years.
Meanwhile, many tech stocks have languished since their 2000 peaks, making them fair game for fund managers who prefer dividends and low valuations. Indeed, Vanguard Equity Income's tech helping has gone from the low single digits to nearly 10% in the past 10 years. Other funds that put a priority on dividend growth as well as yield have between 14% and 18% in tech stocks now. Overall, the average
- source: Morningstar Analysts
What's Risky?
These changes could alter risk profiles of funds with above-average yields, but perhaps in counterintuitive ways. Over the long term (10 years or more), the Morningstar Technology Index has shown more volatility than most other sectors in terms of beta and standard deviation of returns. The credit bubble bust, however, has made the Morningstar Financial Services Index the most turbulent sector over the one-, three-, and five-year periods. Owning competitively entrenched, cash-rich companies such as IBM (IBM), Microsoft (MSFT), and Intel (INTC) rather than banks still recovering from near-death experiences, such as Citigroup (C) and Bank or America (BAC), may prove to be less risky going forward. As J.P. Morgan Chase's (JPM) recent colossal trading losses show, even purportedly well-run institutions are prone to stumbles and are beset with challenges.
Either way, it behooves yield-hungry investors to understand where their yield-oriented stock funds are getting their income from and what risks they carry.
Dan Culloton is an associate director of fund analysis for Morningstar.
