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Dividend funds

Question: Hey Chris, I'm just finishing up my second year at Wake Forest University, and I recently started investing in the stock market with the belief that it will rebound eventually. One of my friends recommended that I invest in dividend funds. From the research I've done and they seem like a very profitable with relatively low risk option compared to individual stocks. But, I feel like they are too good to be true. Can a dividend fund collapse or go bankrupt? Besides looking at there individual holdings what are other indicators that might indicate if a dividend fund is safe? Patrick, Cranston, RI

Answer: It's great that you're investing so early. Terrific. Here's a grief look at dividend funds, also known as equity income funds.

The income from dividend payments typically moderates the volatility of mutual funds that focus on owning dividend paying stocks. That's why these funds are often recommended to retirees that want to stay exposed to the stock market and earn an income. Dividends are a big part of the long-term return of stocks. However, the importance of dividends shrank during the Go-Go '90s when the investing game became a matter of chasing high flying growth stocks that didn't pay dividends. Think dot.com. Companies started hiking their dividends around 2003, and investors have been eager buyers with the tax rate on dividends reduced to a low 15%. That favorable rate is scheduled to disappear in 2011. Dividends will be taxed as ordinary income, although who knows what Congress will do between now and then.

I don't see a dividend fund collapsing or going bankrupt. (It is far more common for a poorly performing mutual fund to be quietly closed or merged with a better performing peer.)

That said, there are risks. The bear market has mauled these funds this year. For instance, the T. Rowe Price Equity Income Fund is down 3.97% year-to-date and it has fallen 35.41% over the past year. The Vanguard Equity Income fund is down 9.11% year-to-date and -34.16 for the past year. What's more, companies usually raise their dividend to keep shareholders happy in good times and bad. But the Great Contraction is forcing a swelling number of companies, especially financial services firms, to slash or eliminate their dividend. According to the Wall Street Journal, there have been 45 dividend reductions and six dividend suspensions among the Standard & Poor's 500 companies.

When it comes to picking an equity income fund the single most common mistake is putting money into the highest yielding funds. The yield is nice, but it also means there is a lot of risk built into that portfolio. I would stick to well-diversified equity income mutual funds with a track record. Better yet, there are equity index funds that focus dividend paying stocks and exchange traded funds (ETFs) that do the same. You research your choices at Morningstar.com. Good luck.

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