Until recently, dividend funds held little appeal among Canadian investors. However, after posting a three-year return of 17% on surprisingly strong sales, dividend funds are staging quite a comeback. Particularly interested are income-oriented investors, who also wish to capitalize on the tax-efficient environment concerning dividends in Canada.

So, what gives for Canadian dividend funds? First of all, they offer income-oriented investors an opportunity to also be equity investors. Plus, dividend funds offer just the right amount of balance between risks and returns.

Most of the fresh, new investors in dividend funds are former income trust investors. Without a doubt, Canadians still like their income trusts, but quite a few had been spooked away upon learning about legitimate concerns regarding income trusts' cash distributions and accounting of capital expenditures. (But, that's another story for another time.)

So, where else could investors used to receiving regular income from their portfolios turn to, but to a similar, income-generating investment vehicle--such as dividend funds!

Aside from income trust investors, many risk-averse Canadians looking for ways to invest in the equity markets have also turned to dividend funds. Not everyone has the stomach for the rollercoaster ride that investing in equities often is. Which is why, it seems, dividend funds are becoming more and more popular. You simply cannot go wrong combining income and capital appreciation in one, easy to understand investment!

Bear in mind, however, that not all dividend funds are created equal. Investors interested in adding this particular asset class to their portfolios should be looking for the so-called "pure dividend funds." Pure dividend funds do not generate income from interest- paying vehicles, such as bonds or GICs, which are also less favorably taxed than dividend-paying instruments. Rather, the income component is derived from quality preferred and dividend- paying common shares.

In Canada, for example, preferred shares issued by banks and utilities have very attractive yields, pay regular dividends, and offer considerable price stability within a fund. And, on top of that, because preferred shares are still largely a forgotten asset class, they are also, quite often, undervalued.

In addition to preferred shares, a pure dividend fund must also include high quality common shares with strong history of steady dividend payouts. Aside from generating income, these common shares also offer potential for capital appreciation.

Of course, the issue of rising interest rates is of concern when it comes to dividend funds because preferred shares are interest-rate sensitive due to their fixed distribution schedules. However, in most cases, the issuer has also built in the right to buy back shares at strike prices. And, having the right to call a preferred share also means that when interest rates are rising, share prices are less likely to decline.

The bottom line is that dividend funds represent one of the few win-win situations left in the equity markets. They offer steady dividend income, which is favorably treated from the tax point of view and which most of our readers are sure to welcome, as well as price stability, which is always appreciated during volatile times. Add to the list of "goodies" the potential for capital appreciation provided by quality, dividend-paying common shares, and you just might have that perfect asset to round up your portfolio.