A fund that yields performance

(Fortune Magazine) -- Spend some time looking for a good mutual fund that invests in dividend-paying stocks, and you begin to think you' ve slipped into an alternative universe. Among the 300 funds tracked by Morningstar that sell themselves as equity - income vehicles, the average dividend yield is a mere 1.5%, which is less than the S&P 500's. And fewer than half of the funds that have been around for the past decade beat the index over that period. To claim that most of these offerings provide investors with equity and income is quite a stretch.

Then there's Alpine Dynamic Dividend (Charts). In a savvy marketing move, Alpine Woods Investments, a privately owned investment firm based in Purchase, N.Y., introduced this fund soon after President Bush's landmark 2003 dividend tax cut, which lowered the top tax rate on most dividends to 15%. Three years later the fund' s results suggest that it has more going for it than just a catchy name. Since its launch in September 2003, the $535 million fund has returned a spectacular 18.7% per year, outpacing the S&P 500's 10.7% gain by a wide margin. As for its yield, it's a staggering 13% - by far the highest in its category.

Credit smart stock picking - and fancy trading - for the fund's success. Co-managers Jill Evans, 40, and Kevin Shacknofsky, 33, have developed a unique and somewhat quirky strategy to hunt for three kinds of dividend-rich stocks. One part of the portfolio consists of fast-growing companies with moderate yields. One of their favorites in this category is Computer Programs & Systems (Charts), a $350 million outfit that provides IT systems to small and midsized hospitals. The company initiated its dividend just three years ago, but it has raised it every year since then, and the stock now yields 4%. Annual profits are projected to grow 16% for the next several years.

Second, the co-managers look for turnaround situations or value stocks with a catalyst for growth. Caterpillar (Charts), the construction equipment giant, is one of their favorites here. Shares have pulled back in recent months on fears of a sharp slowdown in the U.S. economy. But the two managers believe the company's strong international business, which accounts for half of sales, will keep profits growing at a double-digit rate through 2008. The stock trades at 12 times projected 2006 earnings and yields 1.6%.

The third prong of their strategy is the biggest contributor to the fund's rich yield, and is where the quirkiness comes in. Here -Evans and Shack-nofsky trade in and out of stocks that are about to pay dividends. The tax law requires that a stock be held at least 61 days for shareholders to get the favorable 15% tax rate, so the co-managers try to make that their minimum holding period. While many of the stocks they buy using this - dividend capture - strategy are banks and utilities that are about to pay regular quarterly dividends, some are companies on the verge of making one-time payouts. The managers bought Microsoft before it paid a special $3-a-share dividend in 2004 and recently purchased specialty-chemical maker Ashland (Charts), which has announced that it will pay a cash dividend of $10.20 a share on Oct. 25. Since inception, the managers say, they have nabbed about 150 of the more than 1,000 special dividends that have been paid out around the globe.

This strategy isn't without risks, because some stocks fall hard after making these exceptional payments. To avoid the problem, the managers try to steer clear of companies with weak fundamentals that are being propped up largely by the cash on their books. "We cherry-pick the best ones," says Evans.

One quibble with the fund is that the rapid trading drives up costs. Turnover is roughly 200%, which means the managers hold the typical stock for just six months. As a result, the fund's 1.23% expense ratio is about ten basis points higher than the average equity - income offering, according to Morningstar analyst Dieter Bardy. Still, for investors searching for a good dividend-focused fund that actually provides both capital appreciation and income, Alpine Dynamic Dividend is a compelling choice.