Some investment funds target stocks that generate high dividend yields and use the reinvested dividends to boost returns, writes Laura Slattery

At times like these when investment markets are going through a rough patch, taking the gloss off even the smartest of stock picks, the rate of dividends that companies pay out becomes more important to investors.

People who are not interested in watching every point on the share price graph before choosing that perfect second in which to buy or sell will often be attracted to companies that tend to pay their shareholders high dividends.

They can then either use the dividend payout as a source of regular investment income or reinvest it.

Some investment funds target stocks that generate high dividend yields and use the reinvested dividends to boost returns.AIB's Select Yield Focus Fund, for example, invests in a portfolio of shares of well-established companies that, on the whole, will have a relatively high dividend yield.

Ian Cooke, who manages the fund for AIB, notes however that "there are some low-yielding companies in there, so that we can have a balance between companies that will give good capital appreciation and high dividend yields," says Ian Cooke, who manages the fund for AIB.

Not all high-yielding equities are suitable for investment, he adds. "We're not going to buy the most leveraged companies. We're looking for companies that can consistently increase dividends over a period of time," he says.

"Companies should be increasing the dividends they pay by about 5 per cent per annum."

The fund aims to hold equities with a market capitalisation of at least €1 billion across a wide range of industry groups.

"We are overweight in industry groups where we think it is appropriate, such as material stocks and energy stocks. Because of their low rate of dividend payouts, we tend to be underweight in the information technology sector," Cooke explains.

Capital appreciation in the fund is running at about 5 per cent per annum. The return from dividends is a further 3 per cent per annum - around 1 per cent higher than the average on global equity markets.

Investors don't have to reinvest their dividends, but most do, says Cooke. According to research in 2004 by the journal International Bank Credit Analyst, reinvested dividends have accounted for 59 per cent of world equity returns in dollar terms.

"Dividend reinvesting is a very powerful tool," Cooke says. For example, a company paying a dividend of 3 per cent, and increasing this dividend rate by 5 per cent per annum, will be paying a yield of 3.65 per cent on the initial investment at the end of five years and 4.65 per cent at the end of 10 years.

The Select Yield Focus Fund is available as a 100 per cent equity fund, or investors can opt to invest 60 per cent in equities and 40 per cent in fixed-income assets.

Similarly, there are two options under the Canada Life Dividend Bond, which was launched three years ago to capture the attention of investors who had been burnt chasing fast-rising, fast-falling dotcom stocks and were looking for an inflation-beating home for their money.

Investors can also choose between a 100 per cent equity version or, under a more cautious option, to place 65 per cent of their cash in high-yielding equities and the remaining 35 per cent in bonds.

The dividend fund, which is managed by Setanta Asset Management, can also be accessed through its Active Guaranteed Bond, which has a capital guarantee after six years. The companies selected must not have cut their dividend in the past five years.

The 100 per cent equity version of the bond is the biggest seller, according to a spokesman for Canada Life. Its product is also open to smaller investors: the minimum investment is just €10,000, compared to the €75,000 needed to invest in AIB's fund.

Investors can elect to receive their dividends twice a year, with the level of income determined by the dividends paid by the 35-40 companies in which the bond is invested. The current dividend return is running at about 4 per cent, according to the spokesman.

But 80 per cent of investors choose the "non-distributing" option.

In this situation, the dividends are collected as normal with the bond, but instead of being paid out they are reinvested into the bond, thus boosting the amount of money that is invested in the bond and potentially benefiting from any growth in the share price.

There is also a "flexible income" facility under which investors can choose to receive a flat amount or a percentage of the bond value from the sale of units from the bond. This can be made out on a monthly, quarterly, half-yearly or yearly basis.

Dividend funds tend to be on the conservative side. Because companies that pay high dividends are often mature, well-established stocks, their potential for share price growth may not be as high as some younger, more dynamic companies that are still expanding.

Canada Life actually cautions in the Dividend Bond brochure that in the case of shares with a high dividend, "capital growth is likely to represent a smaller proportion of the total return than would be the case with the broader market".

On the other hand, the type of companies included in these funds should prove less prone to volatility and should be able to hold their own in times of turbulent markets.

"High-yield funds are popular with many equity investors who wish to take a long-term view and don't necessarily wish to be particularly active in buying and selling stock," says Ian Mitchell, director of Deloitte Pensions and Investments.

"High-yield funds would tend to be viewed as being moderate risk investments in comparison to some of the more specialist equity funds," he adds.

"Maximum benefit is derived from these funds through buying and holding on. They are not funds of choice for investors seeking to make a quick kill," Mitchell says.