Dividend

As the U.S. Federal Reserve trims its purchases of bonds and expectations of higher interest rates grow, investors are pulling billions of dollars from funds focused on dividend-paying stocks.

Instead of prizing the funds as a complement to bonds as they did when long-term interest rates were flat lining, they are starting to rotate in other directions, in some instances to alternative funds using hybrid stock and fixed-income investment strategies.

Its a change in tactics that many investment advisers have been calling for since last summers steep rates jump, which came after markets became jittery about signals of an unwinding of the Feds economic stimulus program.

Still, portfolio managers warn that as rates go up over the next several years, it would be a mistake for investors to abandon all types of dividend-paying stocks.

Even in a time of rising interest rates, some companies are financially sound enough to keep producing higher rates of dividend growth, said Michael Jones, chief investment officer at RiverFront Investment Group, which manages about $4.2 billion in assets.

Since mid-November, investors have pulled nearly $3 billion net from dividend paying mutual funds and exchange-traded funds, according to fund tracker Lipper. That comes after the group had more than $79 billion in net inflow over a three-year period through 2013.

The shift comes as other types of income-producing funds are becoming more attractive. In early 2009, the 50 highest-paying stocks in the S&P 500 Index averaged yields about 7.6 percentage points greater than 10-year Treasurys, according to Bank of America Merrill Lynch. The top 50 dividend payers in the S&P 500 now have a less-than 2 percentage point average spread over benchmark Treasurys, Merrill Lynch estimates.

Valuations are also favoring dividend funds that lean less to yield and more to growth. The median price-earnings ratio of blue chip companies that are growing dividends by 50% or more is 15.6, based on expected 12-month earnings, according to Merrill Lynch. Thats in-line with its average since 1990.

By contrast, the highest yielding blue chip stocks are trading at similar multiples, but about 25% higher than their long-term averages. Our view is that people arent giving enough attention to the power of dividend growth, said Dan Suzuki, a Merrill Lynch equities analyst.

Companies emphasizing dividend growth as part of their business strategies and showing lower exposure to market volatility should return about 7% a year on average over the next decade, according to a new forecast by Riverfront Investment Group. The study, which tracked performances for both types of stocks over the past 85 years, predicts that the highest-yielding stocks will gain about half as much in that same period.

We still see these (dividend) ETFs as a good way to enhance a portfolios income, but were steering clear of high dividend paying funds that look more like proxies for bonds than stocks, said Mark Eshman, chief investment officer at ClearRock Capital, which manages $400 million.