Dividend yield funds: Quality investment portfolio is key, say experts

Restrictive mandate can result in these schemes missing out on good opportunities

After giving negative returns (category average -7.9 per cent) in 2018 and meagre returns (3.6 per cent) in 2019, the dividend yield category has bounced back.

Its one-year category average return currently stands at 66.6 per cent. Before committing money to these funds based on past returns, investors need to understand their nature and potential risks.      

Where do they invest?

Dividend yield of the stocks these funds pick must be higher than a threshold level. “We look for good current dividend yield, earnings growth, and free cash flow generation,” says Swati Kulkarni, executive vice-president and fund manager, UTI Asset Management Company (AMC).

Kulkarni has been managing the Rs 2,618.46 crore UTI Dividend Yield Fund since 2005.  She believes companies that have good earnings growth prospects can keep raising their dividends. Currently, she selects stocks whose dividend yield is higher than 1.3 per cent. At any given point, more than 70 per cent of her fund’s portfolio is in high dividend yield stocks.

Tata Mutual Fund's new fund offer (NFO) for Tata Dividend Yield Fund is on at present and will close on May 17. “The dividend yield of the stocks we will invest in will be more than that of the Nifty 50. In addition, these companies should have catalysts that can drive re-rating over 12-18 months,” says Rahul Singh, chief investm­ent officer-equities, Tata Mutual Fund.

Sound fundamentals   

These funds invest in high-quality companies. “The portfolios of these schemes generally consist of well-established companies with robust balance sheets,” says Chintan Haria, head-product and strategy, ICICI Prudential Mutual Fund.    

Over a 10-year period, dividend yield funds have given a compound annual category average return of 11.1 per cent. “This universe gives an opportunity to invest in stable growth companies as well as value picks. This combination has worked well in the past and could continue to do so, given that the value theme is gaining prominence,” says Singh. Over the past 14 years, he says, the Nifty Dividend Opportunities 50 Index has given a compound annual return that was 2 percentage points higher than the Nifty 50.

Dividend yield funds invest in companies with stable earnings streams and profit pools. “The corollary to this is that these funds tend to be less volatile,” says Prateek Mehta, co-founder and chief business officer, Scripbox. Adds Singh: “Historically, the Nifty Dividend Opportunities 50 Index has performed better than the Nifty 50 when the market corrects.”

Haria says dividend yield funds tend to be attractive in a low interest-rate environment.

Restrictive mandate

These funds have a more restrictive mandate than, say, flexi-cap funds. “In some years, enough stocks may not be available that meet the two criteria — high dividend yield and good free cash flow. That can cause underperformance vis-a-vis funds with more relaxed mandates,” says Kulkarni. Many stocks in sectors like pharma or banking do not pay out high dividend yields and can’t be a part of these funds.

Kulkarni says that stock selection based on sound fundamentals, however, enables these funds to perform over the long term.

Be prepared for periods of underperformance. “When a rally is driven completely by the growth theme, this category could underperform,” says Singh. The average return of this category has been negative in 2011, 2013, 2015, and 2018.  

Despite the recent run-up, investors could garner good returns from these funds if they have a seven-year horizon and take the systematic investment plan route. Of the 20 per cent of the equity portfolio that should be invested in value-oriented funds, 5-10 per cent may be allocated to dividend yield funds (a subset of the value category).