Dividend yield funds: For risk-averse investors seeking lower volatility

Dividend yield funds have not attracted significant investor interest, with merely Rs 214 crore inflows in January 2025 — the lowest among equity-oriented schemes. Despite being one of the oldest categories, these funds hold the smallest assets under management (AUM) of Rs 31,049 crore as of January 31, 2025. However, they are well suited for today’s volatile market as they have the potential to offer stability.

 

“Dividend yield funds (DYFs) enable investors to get exposure to companies with well-established track records and healthy cash flows, both of which are essential ingredients for companies to deliver compounding growth over the long term,” says Shiv Chanani, senior fund manager–equity, Baroda BNP Paribas Mutual Fund.

 

How they operate

 

Dividend yield funds primarily invest in dividend-yielding stocks. The dividend yield, calculated by dividing the per-share dividend by the share price, serves as a valuation metric. For instance, if a share priced at Rs 100 offers a dividend of Rs 2 per share, the yield is 2 per cent.

 

They mostly invest in stocks belonging to stable sectors. “Many companies that have consistently paid high dividends and shown steady growth belong to stable sectors such as fast-moving consumer goods (FMCG) and information technology (IT), known for high pay-out ratios, strong return on capital employed (RoCE), and stable cash flows,” says Amit Premchandani, fund manager–equity, UTI Mutual Fund. 

 

Limit market volatility

 

High dividend yield stocks are better positioned to withstand market turbulence.

 

The dividend yield acts as a cushion that prevents stocks from falling further. “Conceptually, higher dividend yields provide downside protection during times of stress or market dislocations, as some part of the total return comes from yield, unlike companies that do not pay dividends,” says Premchandani.

 

“DYFs invest in companies that generate healthy profits and free cash flows. Hence, these companies are likely to witness lower volatility compared with the overall market,” says Chanani.

 

S Sridharan, founder and chief executive officer, Wallet Wealth, adds that the downside is largely protected as these companies have robust balance sheets.

 

Tax advantages

 

Dividends received by investors from stocks are taxed at their slab rate. However, when they invest through a DYF, taxation occurs only upon the sale of units, and that too at a lower rate of 12.5 per cent if the fund was held for over a year (and qualifies for long-term capital gains).

 

Growth limitations

 

These funds, which invest mostly in high dividend yield stocks, can miss out on high-growth opportunities. Companies in their growth phase typically reinvest earnings rather than pay dividends, and reward shareholders through rising stock prices.

 

“These funds may also not be able to invest in some of the very high-growth companies which may be loss-making at that point but may hold long-term promise,” says Chanani.

 

Sridharan warns that these funds often also suffer from sectoral concentration.

 

Suitable for risk-averse investors

 

Dividend yield funds are ideal for conservative investors seeking equity exposure with lower volatility.

 

“On a long-term basis, investors looking to reduce the risk of volatility in the portfolio, yet willing to take the risks associated with equity investing, should consider this fund as part of their core portfolio,” says Premchandani.

 

Sridharan recommends a minimum five-year investment horizon and suggests allocating up to 30 per cent of the overall portfolio to these funds.