What Are Dividend Yield Funds?

High dividend yield stocks usually perform well in a rising interest rate environment when investors value cash flows more.

With companies preparing to announce their final dividends over the coming months, there has been a surge of interest in high dividend yield stocks.

However, investors should consider whether they should try to reap the benefit of high dividends by investing directly in stocks, or if the dividend yield fund route is the superior option.

Understanding dividend yield

Novice investors find high dividend yields very alluring.

A 100 per cent dividend signifies a payout equivalent to the share's face value.

For example, if a stock has a face value of Rs 10 and declares a 100 per cent dividend, the shareholders receive Rs 10 per share.

The dividend yield, calculated by dividing the per-share dividend of Rs 10 by the share price of, say, Rs 1,000, is merely 1 per cent.

Companies occasionally announce special dividends, which are sizeable, when they sell assets or to commemorate milestones. But such high dividends are typically unsustainable.

Investing in stocks with the aim of earning a high dividend yield poses several challenges.

One, identifying companies that will consistently pay high dividends in the future is not easy.

Two, dividends are taxable in the hands of investors at slab rate.

Three, investors often squander small amounts of dividend, instead of reinvesting them to enjoy the benefits of compounding.

The fund alternative

Dividend yield funds, which construct portfolios consisting of stocks that pay relatively high dividend yield, offer a solution to these issues.

Fund managers are likely to do a better job of selecting stocks with a high probability of future earnings growth, ensuring that high dividend payouts are maintained.

As mutual funds are pass-through entities, there is no tax incidence at the scheme level on receipt of a dividend, or when the fund manager books capital gains.

Fund managers also carefully reinvest any dividend the fund receives.

Dividend yield funds are also more tax-efficient for investors.

"The dividend earned by a dividend yield fund is added to its net asset value (NAV).

"If an investor withdraws from the scheme after one year, he pays long-term capital gains tax.

"Long term gains up to Rs 1 lakh in a financial year don't attract any tax," says Parul Maheshwari, certified financial planner. Any amount above Rs 1 lakh is taxed at 10 per cent.

Santosh Joseph, CEO and founder, Refolio Investments, emphasises the diversification benefit of dividend yield funds since they typically invest in a basket of stocks, thereby reducing stock-specific risks.

Lower exposure to growth stocks

High dividend yield stocks usually perform well in a rising interest rate environment when investors value cash flows more.

We are currently experiencing such a phase. However, as these funds mainly hold high dividend-paying stocks, they have lower exposure to growth stocks, which offer the possibility of capital appreciation and tend to outperform in bull markets.

"Dividend yield funds may not provide the same level of growth potential as other types of mutual funds," says Joseph.

Limit your exposure

Joseph is of the view that conservative investors looking for a steady income stream may allocate some money to dividend yield funds.

S Sridharan, founder and CEO, Wallet Wealth, cautions that investors should not invest in these funds based solely on recent performance.

If you wish to invest in dividend yield funds, consider taking limited exposure.

"Conservative investors with a low-risk appetite, who are willing to include equities in their portfolios for the purpose of beating inflation, may allocate 8-10 per cent to such funds.

"Hold them for more than five years. Use the systematic withdrawal plan (SWP) route, which is more tax-efficient, for earning a regular income," suggests Maheshwari.

Sridharan is of the view that retirees may have higher exposure to these funds.

"Retired people, who have some risk appetite and want tax-efficient returns, may invest in dividend yield funds," says Sridharan.

"Of their allocation of 20-30 per cent to equities in their overall portfolios," he adds, "they may allocate 10-20 per cent to these funds."

 

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Feature Presentation: Ashish Narsale/Rediff.com