Funds That Serve Up Big Helpings of Cash
By Oliver Ryan FORTUNE reporter

(FORTUNE Magazine/ NEW YORK) - Mutual fund investors seeking dividend income often meet with frustration. That's because it's standard industry practice to deduct management fees from a fund's current income distributions.

With domestic-equity mutual fund expenses at about 1.4% and the S&P 500 dividend yield only at 1.75%, there hasn't been much left for shareholders. Even among U.S. stock funds that emphasize income as part of their investment strategy, the average payout is only 1.76%, according to Lipper.

Now, though, investors have a better option in the form of exchange-traded funds designed for income investors. ETFs are baskets of securities, usually pegged to an index, that you buy and sell on exchanges like stocks. The primary virtue of ETFs for yield investors is that their expense ratios tend to be tiny--.37% on average--so almost all their dividend income is passed on to investors.

The first income ETF out the gate was iShares Dow Jones Select Dividend Index (DVY), which has taken in nearly $7 billion since its Nov. 2003 debut. Now rivals are popping up. PowerShares has launched three dividend funds, including the High Yield Equity Dividend Achievers (PEY). The Amex launched its SPDR Dividend ETF (SDY) in November, and Vanguard expects to introduce a Dividend Achievers Index fund later this year, available as either an ETF or a conventional mutual fund.

How do you choose? The iShares fund, the only one with a multiyear track record, has delivered a total return (yield plus market gains) of 13.8% since inception. In theory, all the funds will perform similarly. They all hold stocks with a solid history--typically ten years or more--of uninterrupted and increasing dividend distributions, which leads them to own lots of financials and utilities.

But there will be differences. The iShares fund, for example, has 62% of its assets tied up in financials and utilities and a current yield of 2.9%. The more aggressive PowerShares High Yield fund has nearly 85% in the two sectors and yields 3.3%. So while these funds offer fat payouts, don't forget that they are stock funds, and the lack of diversification carries risk. The higher the yield, the greater risk of loss if, say, rising interest rates send the financial or utility sectors into a slump. Top of page