Mutual fund investors looking to benefit from the proposed elimination of taxes on dividends might consider value funds and utility funds for their portfolios.
The reason is simple -- these funds tend to have a relatively high concentration of shares in companies that pay dividends, a different strategy from growth-style funds or other sector funds, such as technology or telecommunications.
Dividend-paying stocks tend to be blue-chip issues, such as IBM, General Electric and Procter & Gamble, and they are widely held in value-style mutual funds, particularly those that concentrate on large companies. Utilities include electrical and gas companies such as the Washington area's Pepco Holdings and WGL Holdings Inc.
President Bush's proposal earlier this month to end the tax comes as dividends have gotten renewed attention from investors. The dividend payout represents a dependable source of income, much appreciated by bear-market-fatigued investors who've seen stock prices drop for three years.
Fund investors should keep in mind that the potential gains from investing in value or utility funds -- assuming the dividend tax cut gets the approval of Congress -- will likely be modest, in keeping with the yields on these funds.
"We are looking at yields that are low even on the value side," said Rosanne Pane, mutual fund strategist for Standard & Poor's. For example, Pane said, the average yield on large-capitalization value funds is 2.41 percent, equivalent to the average yield of stocks in the S&P 500-stock index, one of the broadest measures of the stock market.
Yields could grow as dividend payouts become more attractive and if more companies offer them, but that is certainly no guarantee. For years, companies have been decreasing or eliminating their dividends because investors preferred that the companies reinvest all their profits to maximize growth.
"Bottom line . . . you are not going to get funds that have extremely high yields," Pane said. "The best thing to do is look at funds that are focusing on corporate dividends and companies that have the ability and the cash to increase their dividends."
Unfortunately for investors, the funds with some of the highest dividend yields -- those that focus on real estate investment trusts, which are required by law to pay dividends -- would be exempt from the dividend tax cuts.
When looking for funds that are heavy on dividend-paying stocks, investors should consider the underlying holdings of individual funds. While a fund may be labeled a value fund, it could include shares of companies that are more growth-oriented. Additionally, there are few funds that have the word "dividend" in their name -- among them being the Huntington Dividend Capture funds.
Aside from buying more value funds, there are other ways for investors to take advantage of the elimination of dividend taxes.
Investors should think about where they hold specific kinds of funds, for example, putting higher-yielding funds into taxable accounts. They might also put growth-style funds, which can produce taxable capital gains that are typically bigger than their value counterparts, into tax-exempt accounts such as a 401(k).
Of course, before doing this, investors may want to seek the advice of an accountant to consider tax consequences.
But, ultimately, investors thinking of buying value funds or utility funds should do so because doing so would fit with their overall strategy, not because they expect fatter returns as these funds become more sought-after.
The elimination of the dividend "will be a reward for investing smartly," said Arthur Hogan, chief market analyst at Jefferies & Co. "It is a good lesson -- Investing 101 -- of investing not just in growth but in total return and value."