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Should dividend yield funds be part of your portfolio?

Touted as the best bet in bearish times, do these funds really need to be part of your portfolio?

The US business magnate and philanthropist John D Rockefeller once mentioned, ‘do you know the only thing that gives me pleasure? It's to see my dividends coming in’.

Dividends are eagerly sought by a certain set of equity investors. Back home, when the equity market took a free fall early this year, some advisors recommended dividend yield equity funds for its conservative investors. 

Touted as the best bet in bearish times, do these funds really need to be part of your portfolio? 

Its definition

Let’s understand them. These are funds that invest at least 65 per cent of their equity portfolio into high dividend-yielding stocks. The latter refers to stocks that are a part of Nifty dividend opportunities 50 Index or have a dividend yield higher than that of Nifty 50 at the time of investment.

How is a dividend yield calculated?

It is calculated by dividing the dividend per share by the latest share price of a company and multiplying the result by 100. For instance, if a company pays an annual dividend of Rs 10 and its latest share price is Rs 200, dividend yield is 5 per cent (10/200*100). 

As the dividend paid increases, the dividend yield also increases. It can also increase with a fall in the share price of the company. 

The dividend yield of Nifty dividend opportunities 50 index is currently hovering around 3.7 per cent and had gone up to 5.76 in March ‘20 when the stock market hit a low (see chart). 

Why invest in dividend-yielding stocks?

Dividend track-record of a company largely communicates about its financial well-being. After all, it can pay consistent dividends only if it generates cash. It is a popular measure of value-based investment process.

Usually, companies from mature or non-cyclical businesses pay dividends. These companies might be highly profitable but not have much investment opportunities; so it will share its profits with the shareholders in the form of dividends. ITC, Infosys, Hindustan Unilever, TCS and Nestle are the top stocks in terms of weightage in the Nifty dividend opportunities 50 index. FMCG and the technology sector itself constitute 53 per cent of this index.

In a bearish market, their dividends might provide downside protection to its stock prices. Since, if their share prices fall, they start looking attractive in terms of dividend yield. 

However, all stocks with high dividend yields aren’t necessarily attractive. Some stock price correction might be because of weak financials - which will reflect later in terms of lower or skipping of dividends in the future. So, fund managers usually juxtapose dividend yield along with other filters to construct their stock portfolio.

Dividend v/s price appreciation

Historically, Indian shareholders have earned much more from share price appreciation than in the form of dividends. Nifty 500 TRI was up 126 per cent in the last 10 years as against 101 per cent for Nifty 500. It hints at a dividend comprising just 20 per cent of overall index returns. 

Fund performance

Only one fund out of a handful managed to beat the S&P BSE 500 TRI. Moreover, these funds lag the performance of large-cap funds – on risk as well as return measures. On a risk-adjusted return basis, large-cap equity funds have been found to be better than dividend yield funds. They are less volatile than dividend yield funds, while also giving higher average returns for the period.

Dividend yield funds also have higher exposure (42% on an average) in mid and smallcap stocks that make them a riskier lot. 

Takeaway

Dividend yield equity funds might provide downside protection during bearish times, but their overall performance isn’t encouraging. Investors are better-off with large-cap equity funds which provide superior risk-return trade-offs. 

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