6 ideas for dividend hunters

With bond coupon rates at historic lows, investment categories that offer alternative sources of yield have been among the most popular in recent months. We see this trend continuing and believe that investors should take comfort in the academic evidence supporting dividend investing and the total-return approach.

Since 1927, high-dividend-paying stocks have returned 11% per year, beating the 8% return from nonpayers and resulting in an ending wealth that is eight times larger. Better yet, they accomplished this while incurring less volatility.

But dividend-paying stocks outperform only over the long haul, so why might 2012 be a particularly good year for these equities?

First, stocks offer a better relative value than bonds. Second, large-cap quality stocks are selling at a discount compared with riskier small-cap stocks. Unlike small caps, large caps have the capacity to withstand continued slow economic growth.

Stocks are reasonably priced relative to bonds. In the four years before the start of the financial crisis in October 2007, investors poured $875 billion into stock exchange-traded funds and mutual funds. Stock funds captured 50% of each dollar invested. But in the four years since, investors have avoided stock funds, instead putting 68% of all fund flows into bond funds.

That severe risk aversion has led stocks to appear attractive relative to bonds.

In fact, the yield differential between the 10-year government bond and the dividend yield on the Standard & Poor's 500 Index ($INX) has not been this attractive since the 1950s. At that time, we were coming out of a period in which the Federal Reserve pegged interest rates at artificially low levels to help the government fund World War II. In the 30 years prior to 1980, the S&P 500 returned 6% per year, after inflation, compared with negative 2% from long-term government bonds.

Within stocks, we prefer large caps and low-risk stocks to smaller-cap or pricier stocks. Economic growth will likely remain subpar, so we want to avoid high-beta stocks and those pricing in an expectation for rapid growth. But even with slow growth, dividend-paying stocks should be able to maintain their payouts. Payout ratios are below their historical average, so companies could boost payouts to maintain their dollar amounts.

In addition, companies have built sizable cash buffers, which could be used to increase payments.

With that investment thesis in mind, here are some of the funds that we recommend.

Vanguard High Dividend Yield Index ETF

Vanguard has two exchange-traded funds on this list, and of the two, Vanguard High Dividend Yield (VYM, news) offers a higher yield and a large-cap-value tilt.

It is low-cost and widely diversified, so it could serve as a core fund. It will likely have a fair amount of overlap with your other large-cap funds.

Despite industry practice, the "high yield" in the name is not a euphemism for junk -- this is a Vanguard fund, after all.

Wisdom Tree DEFA

Wisdom Tree DEFA (DWM) is just one recommendation from a stable of high-yielding international ETFs from Wisdom Tree. This one weights companies according to the amount of dividends paid, resulting in a large-cap-value tilt.

While dividends are more common overseas, they are also a good check on corporate governance, particularly when investing in foreign markets where due diligence is more difficult.

PowerShares FTSE RAFI US 1000

The ProAssurance (PRA, news) exchange-traded fund is not marketed as a dividend fund, but it incorporates dividend information, along with sales, book value and cash-flow data. The result is a more stable approach than using dividends alone -- after all, many top-performing companies pay no dividends.

This is the most well-balanced core fund you'll find on this list.

Vanguard Dividend Appreciation ETF

The Vanguard Dividend Appreciation ETF (VIG) is a perennial favorite, and while this fund does not have a high yield, it earns points for stability.

Companies in this fund need to increase dividends for 10 consecutive years, which limits exposure to cyclical industries.

Companies with strong brand names and stable repeat businesses are often able to consistently grow dividends. Thus, it is little wonder that stocks such as McDonald's (MCD, news), Coca-Cola (KO, news) and Procter & Gamble (PG, news) make the list.

iShares High Dividend Equity

The iShares High Dividend Equity (HDV, news) exchange-traded fund was launched last year and quickly gained assets. It is still much smaller than iShares' other dividend-focused fund, the iShares Dow Jones Select Dividend (DVY, news).

HDV screens for high-yielding stocks that pass both qualitative and quantitative tests for stability. This results in a high yield without sacrificing quality. (Morningstar licenses HDV's index to BlackRock and earns asset-based fees.)

The higher the yield, the higher the risk

Not all of the funds we like sport attractive yields, but investors need to remember that the higher the yield, the higher the risk. Instead, we prefer that funds take steps to ensure quality stocks and mitigate stock-specific risks.

We would avoid high-yielding funds with abnormal sector concentration. For example, DVY had nearly 50% of its assets in financial stocks in 2007, right before the financial crisis. Defensive sectors such as consumer staples and utilities have outperformed the market over the past year and are no longer attractively priced. The stocks in the Utilities Select Sector SPDR (XLU) offer a 4.1% yield, but our analysts think that utilities stocks are currently fairly priced, offering little downside protection compared with the rest of the market, which is priced at about 83% of fair value.

More from Morningstar:

• Readers' lists of high-conviction holdings
• Keep these dividend payers out of your taxable account
• 10 dividend stocks our ultimate stock-pickers should consider