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May 3, 2010, 7:48 p.m. EDT

Investors Increasingly Yield to the Dividend

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By Jonathan Burton

Dividends are coming back in style with investors, and they aren't just for widows, orphans and coupon-clippers any more.

The tumultuous first quarter of 2009 was the darkest ever for dividends, with more companies slashing payouts than raising them. Dividend-paying stocks have also lagged their nonpaying peers in the rally since March 2009.

Now dividend-paying stocks, and the mutual funds and exchange-traded funds that own them, are being seen in a brighter light. U.S. companies are generally in much better financial shape because of sharp spending cuts in the recession and improving sales as the economy has recovered—and management increasingly is choosing to share the wealth.

"The climate is very positive for dividend stocks," said Harry Domash , publisher of DividendDetective.com, a dividend-stock website. "A year or so ago, it was about finding stocks that weren't going to cut their dividend and go out of business; now it's about finding high-yielding stocks in good sectors."

Stock dividends in fact have become attractive bond alternatives, with their predictable and often higher income stream, plus the potential for price appreciation. But stocks typically are riskier than bonds, and smart dividend investors know there is more to this strategy than simply buying the highest-yielding names—tempting as that may be in today's low-yield environment.

"A dividend is not going to make a bad business into a good stock," said Josh Peters , editor of Morningstar DividendInvestor, a newsletter from investment researcher Morningstar Inc.

"Management shares the growth of the business directly with shareholders through dividend increases," Mr. Peters added. "I would not consider buying any common stock that didn't have the capacity to grow its dividend, because it's a vital sign of financial health."

Many mutual funds and ETFs offer dividend-centric portfolios. Yet finding the right dividend investment isn't solely about yield and return; you also have to incorporate two key factors that are in your control—risk and cost.

Using a screen developed by Christine Benz , Morningstar's director of personal finance, Morningstar searched for diversified U.S. stock funds that sport 12-month trailing yields of 2% or better, with below-category-average risk and expenses.

The results produced 18 retail funds with five-year returns. Topping the list: Vanguard Equity-Income /zigman2/quotes/204144399/realtime VEIPX -0.50% (trading symbol VEIPX); Vanguard Dividend Growth (VDIGX); American Funds American Mutual /zigman2/quotes/200625334/realtime AMRMX -0.46% (AMRMX); ING Corporate Leaders Trust Series B /zigman2/quotes/203946829/realtime LEXCX -0.66% (LEXCX) and State Farm Growth /zigman2/quotes/203991507/realtime STFGX -0.61% (STFGX).

A companion search produced exchange-traded funds for dividend-oriented investors to consider. The highest-ranked on a yield basis include: iShares Dow Jones Select Dividend Index /zigman2/quotes/204321812/composite DVY -0.63% (DVY); WisdomTree SmallCap Dividend /zigman2/quotes/205763385/composite DES -0.93% (DES); SPDR S&P Dividend (SDY); Vanguard High Dividend Yield Index ETF /zigman2/quotes/205740569/composite VYM -0.53% (VYM) and WisdomTree MidCap Dividend /zigman2/quotes/208396493/composite DON -1.09% (DON).

Other ETFs worth noting: First Trust Value Line Dividend Index /zigman2/quotes/206971334/composite FVD -0.52% (FVD); PowerShares Dynamic Large Cap Value /zigman2/quotes/206944888/composite PWV -0.54% (PWV); Vanguard Value ETF /zigman2/quotes/209016161/realtime VFINX -1.18% (VTV) and SPDR Dow Jones Industrial Average /zigman2/quotes/208954582/composite DIA -1.29% (DIA), dubbed the Dow "Diamonds" in reference to its ticker symbol, which tracks the 30-stock benchmark. Dow Jones, owned by News Corp., publishes The Wall Street Journal.

Write to Jonathan Burton at jonathan.burton@dowjones.com

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