Dividend yield funds brave falling markets

Their good show makes them an ideal fit for conservative investors' equity portfolios

Dividend yield funds, a class of defensive equity funds (they are also regarded as a subset of value funds), have done well during the recent market downturn. All the funds in this category, barring one, have declined less than their benchmarks in the past year. They have also excelled over longer time horizons: all the funds in this category have outperformed their benchmarks over the three-and five-year horizons. Since these funds have provided sound downside protection and also outperformed across market cycles, they should find a place in the conservative equity investor’s portfolio.

Dividend yield funds tend to be resilient during a downturn. “In a weak market, when stock prices are falling, a company that has a consistent track record of dividend payouts usually maintains its level of payout. Stocks of such companies do not fall as much as the rest of the market because the dividend they pay sets a floor to their prices,” says Rupesh Patel, fund manager, Tata Dividend Yield Fund.

The longer-term outperformance of these funds can be explained by the fact that the stocks they invest in have strong business fundamentals. These companies generate so much cash flow that they are not only able to meet their reinvestment needs but also distribute surpluses to their shareholders. Says Shreyas Devalkar, fund manager, BNP Paribas Dividend Yield Fund: “These are stocks with high return on equity (RoE). Such stocks tend to outperform over the long term.” Patel adds that if a fund is able to protect the downside in a volatile market, its chances of doing well over the long term improve.

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Investors should, however, be warned that these funds could underperform in certain market conditions. When markets are witnessing a bull run and most investors are betting on growth stocks, dividend yield funds will underperform because they do not have those stocks in their portfolios. In such conditions, investors will have to display patience and confidence in this investment style.

When selecting a dividend yield fund, look at past performance, giving greater weight to longer-term returns. In addition, look up a few other criteria. One, check how the fund defines high dividend yield. “In Tata Dividend Yield Fund, we define a stock as having high yield if it is higher than the last reported dividend yield of the Sensex,” says Patel. If a fund sets the minimum dividend yield criterion too low, it will give the fund manager the leeway to invest in virtually any stock. Such a fund will not remain true to its mandate.

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Another aspect that you should examine is the fund’s mid- and small-cap exposure. Investors who put their money in such a fund want low volatility. "If dividend yield funds diversify across different market segments, they will be as volatile as the other diversified equity funds," says Renu Pothen, research head, Fundsupermart.com. Make sure that the fund you invest in has at least a 70-75 per cent exposure to large-cap stocks.

While investors with a high risk appetite may avoid these funds or have a 10 per cent allocation to them, conservative investors may allocate 20-25 per cent of their equity portfolio.