Give ballast to your portfolio with dividend yield funds
Written on Saturday, February 20, 2016
By Sudipta Mittu
Capital markets across the globe have entered into a bearish mood owing to developments in China and the tightening of liquidity that is expected to happen in the wake of rate hikes by the US Federal Reserve. Corporate earnings have also not recovered as speedily as was expected, and reforms, especially those that required legislation to be passed by the Parliament, have not progressed as speedily as was expected. The investment cycle too is taking more time to recover than was expected. With emerging markets losing favor among FIIs, India too has paid a price.
In this kind of an environment, where the market has taken on a distinctly bearish outlook, domestic fund investors are looking to add funds to their portfolio that are better equipped to resist the fall in the market than the usual growth fund. They should consider dividend yield funds, which are a resilient category.
How do these funds work: In a dividend yield fund, the first level of filter that the fund manager uses for stock selection is high dividend yield (dividend yield is dividend divided by market price). A fund could, for instance, have the criterion that it will only invest in stocks whose dividend yield is higher than the current yield of a broad market index such as the Nifty. A large part of the fund portfolio, say 65-75%, is chosen based on this criterion. In the rest of the portfolio, the fund manager could pick stocks that don’t have a high dividend yield but have attractive growth prospects.
Why invest in dividend yield funds: Dividend yield funds offer several advantages. It has been witnessed across markets and time horizons that these funds have low volatility. On the scale of volatility, these funds lie between a pure large-cap portfolio and a mid- and small-cap oriented portfolio. When the markets enter a bearish phase, as is the case now, these funds tend to fall less than funds that bet on high-growth stocks.
The use of the dividend yield criterion for stock selection by the fund manager automatically tilts the portfolio of these funds towards stable, high-quality stocks which have healthy balance sheets and generate regular cash flows. The fundamentals of such stocks tend to be less risky. The high-quality portfolio in turn proves to be more resilient in a market downturn. Most dividend paying companies tend to have a very stable dividend policy. They avoid reducing the dividend amount even in a bad year as they don’t want to affect investor confidence in the stock. Dividend yield funds therefore gain from the regular flow of dividend.
Disadvantages of these funds: Dividend yield funds are conservative in nature. They will preserve your capital well in a downturn and provide steady return. But there is a price to be paid for their inherently stable nature. They tend to underperform their growth-oriented peers when the market is on an upswing. Remember that dividend yield funds invest a large part of their portfolio in large, stable companies that generate regular cash flows. These companies are well past their high growth phase, which is characterized by a high appetite for capital. Since these companies do not reinvest a large part of their earnings in the business, they can afford to pay generous dividends. But this also means that capital appreciation tends to be lower in such stocks than in high-growth companies.
Points to remember Experts suggest that you should not invest in dividend yield funds if you have a short investment horizon. You need to hold these funds for at least 7-10 years to be able to reap a handsome return from them.
Most investors in India tend to invest only in growth-oriented funds. Investing in dividend yield funds will lend style diversity and provide a value bent to your portfolio, making it more resilient.