Dividend funds comprise 3.6% of all mutual funds investments with total investment of 15.6 bill. Historically they have provided strong returns - 10.3% over last 10% - better than the equity and bond funds.

The original purpose of these funds was to generate dividend income, which is taxed at approximately 35% lower rate than interest income for an investor in the highest tax bracket of 50%. Consequently, they are appropriate for non-registered accounts.

Traditionally, Dividend Funds have invested in high yield preference shares of interest sensitive companies - banks, financial services, pipelines and utilities. In the 80's, yield on preference shares was over 10%. In addition they offered lower volatility than bonds and equities. Consequently, they offered an attractive and conservative alternative to equity investments. The price for reduced volatility, of course, is that they miss out on the potential for capital appreciation inherent in equities.

Over the years the supply of high yield prefs has dwindled. Also, fund managers have discovered some disadvantages of the prefs. Firstly, in rising equity markets, whereas the dividends in commons can grow, those on prefs have tended not to. Prefs are less liquid than equities and bonds of comparable investment quality. Lastly, as returns on equities have grown in the last bull market, investors expected similar growth potential in the Dividend Funds.

As a result, while the "traditional" Dividend Funds such as those offered by (BPI, Dynamic, Altamira, Spectrum United, CI, InvestNat) continue to invest approximately 65% in prefs and balance in high yield commons, another class of Dividend Funds has emerged to counter some of the disadvantages mentioned above. PH&N, AIM GT Global, First Canadian and Greenline offer funds in this class. The PH&N Dividend Fund, rated as the best with 3-year return of 24%, invest less than 4% in prefs. The rest is invested high yield commons of interest sensitive companies. Some fund managers find ways to "spike" the returns by holding other high-yeild instruments such as income trusts, which adds significantly to the risk.

Lastly, the dividend funds should not be confused with High Income funds. These funds attempt to produce highest current income through investments in bonds, prefs, commons, income trusts and real estate investment trusts (REITs). Unlike Dividend Funds, they are not designed to generate tax-advantaged income.

The attached Schedule compares aspects of Dividend Funds with bond funds. Two Dividend Funds - one from each class discussed above are compared along with group averages.

• The traditional Dividend Funds have much lower risk than those invested largely in commons. Dynamic's risk is less than half that of PH&N's. As expected, the latter has better returns compared to Dynamic and the group average.
• As a group, Dividend Funds have outperformed the bond funds. This is largely due to rise in equity prices in the past 5 years. Going forward, this is unlikely to be the case.
• Bond funds have one-third the volatility of Dividend Funds.