## Dividend Funds: Refined Ranking of Barron’s List

OK, I must confess – one of my biggest shortcomings (and there are a few, for sure) is that I am a perfectionist. A few weeks ago, I wrote a blog that re-examined Barron’s recently published list of top dividend funds.

The point that I originally made (and what I continue to make) is that income-oriented investors are more concerned about the size and stability of dividend income, and are generally less concerned about changes in share price (which was a primary driver of Barron’s rankings).

While it is certainly a much better reflection of how income-oriented investors should analyze dividend funds, it did miss a subtle but important point.

### Factoring In Dividend Growth

While dividend amount and stability are important, one attribute that my prior analysis did not adequately assess is the impact of dividend growth. You see, there is what you may call “good volatility” – for example, a fund that was able to generate increasing dividends each year. Mathematically, a fund that had a rapidly increasing dividend would also show high dividend volatility, and I think we can all agree that this would not necessarily be a bad thing.

### Enhancement to Fund Analysis

To overcome this issue, I analyzed each fund as follows:

- I performed a linear regression on each fund using its five years of historical net dividend (equal to dividends less expenses) performance, based upon the net dividends that would have been received each year for a given investment at the beginning of the five year period.
- Using this regression, I then estimated what the expected net dividend in year 6 would be (essentially, extrapolating the regression line out one year).
- I calculated the standard error of the regression (i.e. how well or poorly the linear regression fit the data)
- Finally, I calculated the ratio of the estimated net dividend from step 2 above to the standard error calculated in step 3 above.

OK, now to attempt to explain what this is doing in plain English.

If we plotted each years dividend on a graph, where the X axis was time and the Y axis was the dividend amount, the regression would be the straight line that would be drawn that “best fits” the plotted dividends over the five years. If the dividends had a general upward trend (or were growing), this would result in line that was sloping upward (i.e. it increases with time). In addition, those funds that produced higher average dividends would have a line that was located higher above the x axis.

Now, the explain the standard error component. This is a measure of how well the regression explains the observed data; said slightly differently, the more the plotted data varies from the straight line formed by the regression, the more “random” or volatile the dividends.

Finally, taking the ratio of the estimated dividend in year six will therefore consider (1) the impact of observed historical dividend growth (through the slope of the linear regression) (2) the impact of this historical dividend level (through the “intercept” of the linear regression, or how high above the x axis the line is located) and (3) the volatility of the dividends.

The ratio of the regressed dividend to the standard error can be thought of as being akin do a “Sharpe Ratio”, but applied to the dividend received instead of share price.

### Results

Here are the results of the analysis (and, as usual, please remember that past results do not necessarily indicate future performance):

As before, this different view of performance leads to very different conclusion than Barron’s analysis. Most of the top funds that appeared in our prior re-ranking also appear at the top of this list, with a few exceptions:

**Principal’s Equity Income Fund**shot to the top of the list (was previously ranked #16 in our prior analysis), primarily because of its consistent track record of increasing dividends over the observed five year period (and very low standard error).**Legg Mason ClearBridge Equity Income Builder Fund**jumped from #32 on our previous list up to #9 due to the increasing trend of its dividends.**Ave Maria Rising Dividend Fund**also experience a big jump, from #31 to #12 due to its very standard error.

Interestingly, none our previous top ranked fund experience a dramatic plunge in the rankings.

### Efficient Frontier for Dividend Funds

Here is an updated efficient frontier diagram, plotting each fund (actually, some outlier funds were truncated from the diagram), with the X axis representing the standard error of the regressed net dividends and the Y axis represented the estimated dividend for year 5 per the regression (as a percentage of the original principal invested at the beginning of the five year period):

As before, the diagram reaffirms that no single measure really identifies an absolute “best” dividend fund. While there do appear to be many inefficient funds (those located outside the yellow shaded area), those in the efficient frontier region offer different combinations of expected dividend levels vs. volatility, or degree of uncertainty, that investors should have on the dividends. For example, the **Principal Equity Income Fund** has an expected net dividend of 1.59% of the original principal invested with a standard error of only 0.03% (the lowest of all funds analyzed), while the **Columbia Dividend Opportunity Fund** (#7 in our ranking) offers an expected net dividend of 2.72% (which is 71% higher than the Principal Equity Income Fund) but with a standard error of 0.36%. Which is better? It depends upon your appetite for income volatility.

### Details

Here is more detail regarding each fund’s historical performance:

### Posted by

John Bevacqua on December 1, 2012

### Filed Under

Advice, Income Strategies, Investing