Curb downside risk amid market correction with dividend yield funds

But limit exposure as they can lag behind growth-oriented peers

Dividend yield funds (direct plans) have given a category average return of 13 per cent over the past year, outperforming several other diversified equity categories, such as large-cap (6.4 per cent), mid-cap (12.3 per cent), and flexi-cap (7.5 per cent). At present, there are eight dividend yield funds, which together manage Rs 9,767 crore (data as on April 30).

When markets get overvalued and witness correction, investors begin to seek refuge in safer avenues. One such option with the potential to generate good returns over the long term is dividend yield funds. These are equity schemes that invest at least 65 per cent of their corpus in high dividend-yielding stocks. Dividend yield is calculated by dividing dividend per share with the price of the share. In bearish times, a high dividend yield helps to contain the downside of these stocks.

Hedge against uncertainty

In uncertain times, savvy investors shift to profit-making companies with strong balance sheets. Dividend yield stocks fall under this category as most dividend-paying companies generate cash on a consistent basis and have sound balance sheets.

“The primary goal of these funds is to identify and invest in high dividend firms by comparing their dividend yield to that of a benchmark index, such as the Sensex or the Nifty50. When the market is volatile, investors gravitate towards fundamentally strong dividend-paying companies, which tend to hold up better than their non-dividend-paying counterparts. Dividend yield funds are used by investors as a hedge against volatility and to add stability to their portfolios,” says Deepak Khurana, director, index and analytics, Asean and South Asia, London Stock Exchange Group.

The dividend declared by companies is taxed at the hands of investors. That makes direct stock investing for the purpose of receiving dividends an unattractive proposition, especially for those in higher tax brackets.

However, the dividend received by an equity sch­eme is not taxed and gets reinvested by the fund manager. For investors who don’t require regular income, and who want to compound their money over the long term, these schemes are a tax-efficient mode of investing for dividend yield.

Although these funds invest primarily in dividend-yielding stocks, the regulator has not prescribed any minimum level of dividend yield which a stock must have to qualify for entry.

The fund manager is also allowed to invest a part of his portfolio in stocks that don’t pay dividends. This can lead to some degree of subjectivity in the management of these schemes.

They may also lag behind during times when monetary conditions are easy and investors are chasing growth stocks without worrying about cash flow (and dividends).

In strong bull markets, investors typically don’t care about the cash flow of businesses and are willing to attribute relatively higher valuations.

Dividend yield funds could underperform in such times. The category average return from these funds was 4.5 per cent in 2019 and minus 5.6 per cent in 2018. Moreover, given the relatively small size of the schemes compared to diversified-equity funds, they tend to have higher expense ratios.

“Investors looking for less volatile performance, especially in current market conditions, may go for these funds. But for the longer term, they will be better off sticking to diversified funds,” says Vijai Mantri, chief investment strategist and co-founder, JRLMoney.

Investors may allocate a part of their investible surplus to these schemes. Since they are thematic offerings, they should be held in the satellite portfolio. Investors may allocate 5-10 per cent of their equity portfolio to them.

According to Amol Joshi, founder, PlanRupee Investment Managers, “Allocation to dividend yield funds can yield good returns, provided you stay invested for a full market cycle of five-seven years.”

As for selecting the right fund from the many available, Khurana says: “Select a fund with a reasonable corpus size, low expense ratio, and historically low volatility.”