Cut Risk With These Two Dividend Funds

Dividends are a shareholder's best friend. They have accounted for about 40% of the total return of Standard & Poor's 500-stock index over the past 80 years. And dividends are cold, hard cash -- the company that pays them out can't take them back. Getting some of your return in the form of dividends helps reduce risk.

But you shouldn't be a yield hog. Prudence argues against simply buying stocks that yield the most. As the bear market demonstrated, receiving a fat dividend is cold comfort if a stock's price collapses. Financial stocks, traditionally high dividend payers, crashed last year, with some getting wiped out.

Nor does it make sense to invest in a stock that's paying a dividend that the company's earnings can't support. The firm may have to slash or eliminate its dividend -- as numerous companies did during the recession. Or, worse, the company will continue paying the dividend and forgo making the expenditures needed for the business to prosper.

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The best strategy is to invest in stocks with a history of raising their dividends -- and a strong likelihood that they'll continue to increase payouts in future years. That means selecting strong companies that consistently boost their profits -- and are run by executives inclined to keep lifting dividends.

Several first-rate funds seek stocks with rising dividends. My favorite is Vanguard Dividend Growth (symbol VDIGX). The fund has returned an annualized 3.9% over the past five years through August 14 -- an average of four percentage points per year better than the S&P 500.

Dividend Growth held up relatively well during the bear market, a cataclysm in which practically everything lost money. The fund tumbled 42% from October 9, 2007, through March 9, 2009. But that was 13 percentage points less than the S&P 500's decline, according to Morningstar. Dividend Growth has been 20% less volatile than the S&P.

The fund boasts other attributes. Annual expenses are just 0.32%. Manager Don Kilbride has been on the job for little more than three years, but his employer, Wellington Management, has run the fund since its inception in mid 1992. Since then, the fund has returned an annualized 6.1% -- more than a percentage point per year less than the S&P 500. That's a small price to pay for the fund's below-average risk.

Kilbride's approach is simple: "The watchword here is quality, quality, quality." He buys only stocks that he's fairly sure will hike their dividends over the next five years. And he buys only relatively cheap stocks. The average price-earnings ratio of his portfolio, based on the previous 12 months' profits, is a modest 12. "I'm very focused on cost," Kilbride says. "I don't like to buy things that are up a lot."

Don't look for a fat dividend from this quality portfolio. Its yield is just 2.7%. The companies Kilbride favors boast strong balance sheets, growing earnings and stable businesses. Among his favorites are payroll giant Automatic Data Processing (ADP); Cardinal Health (CAH), the drug and medical-products distributor; and United Parcel Service (UPS). All have powerful franchises. Cardinal is expected to split into two parts on September 1. True to form, Kilbride plans to retain the lower-risk drug-distribution business and jettison CareFusion, the medical-products business that Cardinal is spinning off.

Vanguard, surprisingly, offers another take on dividend-growth investing through Vanguard Dividend Appreciation Index (VDAIX), a traditional fund, and Vanguard Dividend Appreciation ETF (VIG), an identical but exchange-traded version of the regular fund. Expenses on the regular fund are 0.35%; the ETF charges just 0.24% a year. The ETF yields 2.3%, while the traditional fund yields 2.2%.

For the most part, the funds mirror Mergent's Dividend Achievers Index. The index, which has a fine long-term record, consists solely of companies that have boosted their payouts for at least ten straight years. At Vanguard's behest, Mergent tinkered with the construction of the index before the two funds were launched in an effort to weed out weaker companies.

Blue chips are abundant in the funds' portfolios -- great companies such as Wal-Mart (WMT), Coca-Cola (KO), Johnson & Johnson (JNJ) and ExxonMobil (XOM). The average P/E for the funds' stocks is 13.

I give the nod to the actively managed fund because it has better returns and slightly lower volatility. Both funds, however, are first-rate.

Don't expect Dividend Growth or Dividend Appreciation Index to excel in the kind of furious bull charge we've had since the winter low. The former returned 35% between March 9 and August 14, while the latter gained 41%. Meanwhile, the S&P rocketed 50%.

These funds will make you money the old-fashioned way -- slowly but surely, by investing in sturdy, reasonably priced blue-chip companies.

Steven T. Goldberg (bio) is an investment adviser.