Dividend Yield Funds

What Are Dividend Yield Funds?

Dividend Yield Funds invest at least 65% of their portfolio in equities such that the stocks reward shareholders with high and consistent dividend payouts, bonus shares or share buybacks. These funds can have a value tilt, they can be a blend of growth and value, or they may be growth-oriented.

The aim of these funds is to provide medium to long term gains and/or dividend distribution by investing in equity and equity-related instruments of dividend-yielding companies. Dividend Yield Funds with a value tilt invest mainly in stocks that are undervalued and are trading at a market price that is lower than their intrinsic value.

However, the companies that the funds invest in have strong fundamentals, so the market will eventually realise their actual value.

Who Should Invest in Dividend Yield Funds?

  • Dividend Yield Funds are good for investors who want a regular income in the form of dividends since the mutual funds pass on the dividends from the companies to the investors. Although Dividend Yield Funds can invest across market capitalisation and sectors, most of these funds invest at least 50% of their assets in large cap companies that are mature and have a healthy cash flow in order to pay dividends.
  • Dividend Yield Funds are best for moderate risk takers since these funds are relatively less risky as compared to small cap, mid cap and growth-oriented funds. So, during a downturn, they tend to fall less than the aforementioned funds. Investors who don't want to be affected by volatility can invest in Dividend Yield Funds since the companies the funds invest in are generally capital intensive businesses that are less volatile.
  • Investors who are not confident about picking out dividend yielding stocks on their own can opt for the mutual fund route.
  • The funds provide a high return on investment in the long run. Hence, they are suitable for investors who want to stay invested for at least 5 years.
  • These funds are good for investors who want to avoid a steep tax on dividends. When you invest in stocks that pay dividends, the dividends from stocks are taxed in the hands of the investors at a high marginal tax rate. In the case of the dividend yield funds, the dividends are taxed at a much lower rate.

Taxability of Dividend Yield Funds

  • Low-interest rates make high Dividend Yield Funds attractive for investors who want higher tax-efficient gains. Such investors shift their investment from dividend paying stocks to Dividend Yield Funds to avoid a steep tax on dividends. This is because investors are taxed less when they buy the funds as compared to when they invest in equities with the dividend payout option.
  • If you hold the fund for up to one year, the dividend gains get converted to capital gains. These are taxed at 10%, provided the dividend income is above Rs 5000. This rate is very low compared to the marginal tax rate on dividend payout from stocks which is 30% plus. Thus, Dividend Yield Funds are more tax-efficient than equities with the dividend payout option.

Risk Involved with Dividend Yield Funds

  • It is best to invest in Dividend Yield Funds with a reasonable size corpus. You should avoid funds with a small size corpus since the right investment strategy can make these funds look appealing as compared to other funds, but small mistakes on the part of the fund managers can make plunge the funds to the bottom.
  • Thematic Dividend Yield Funds invest at least 80% of their assets in stocks that are tied to a common theme. These funds are very risky since their success depends upon a theme playing out. If that doesn’t happen, then none of the stocks that the fund managers have invested in will perform well. These mutual funds are suitable only for experienced investors who typically allocate 10% of their portfolio to such funds. Thematic Dividend Yield Mutual funds are very volatile in the short-term, but if they are held for a period of 5 years, the risk comes down substantially.
  • It is important for the companies to have sound management since the future earnings of the companies that determine the dividends depend on whether the decisions of the top management resonate with the ideology of the companies.
  • When markets are rising, a dividend yield fund returns less compared to small cap, mid cap and growth-oriented funds.

Advantages of Dividend Yield Mutual Funds

  • Dividend Yield Funds invest mainly in dividend yielding stocks that have a consistent record of paying timely dividends. The fund house passes on these dividends to the investors. Hence, these funds are perfect for investors who want a regular income in the form of dividends.
  • These funds result in higher tax-efficient gains.
  • Dividend Yield Funds invest in companies that provide protection during market volatility. When markets are bearish, these funds perform better than small cap, mid cap and growth-oriented funds, so the investors benefit. In an underperforming equities market, high dividend yielding companies experience lower volatility, and once the market stabilises, they return gains that are in line with the market.
  • Fund managers also invest in companies that are less risky. These companies don’t depend heavily on debt financing. Companies with high-interest coverage ratios are attractive for fund managers since such companies are generally not risky. The interest coverage ratio of a company determines whether it can pay off its debts. The ratio is calculated by dividing the earnings before income and tax by the company’s interest expense.

Since Dividend Yield Funds invest in several sectors, including IT, pharmaceutical, metals, consumer goods, construction, oil and gas, power, financial materials, chemicals and automobiles, you get good exposure to all the sectors. Moreover, some of these funds even have exposure to overseas stocks.

People who favour investing a small part of their portfolio in thematic dividend yield funds whose success depends on a theme playing out as expected should be aware that these funds delivered 23.14% returns in 2021. Their 3 year and 5-year returns were 17.9% and 14.07% per annum.