Dividend yield funds seen as stable option for sound risk-adjusted returns

These funds may underperform growth funds and lag during bull runs

With equity markets turning volatile, investors are seeking funds that can cushion their portfolios. Many are looking at dividend yield funds, which have underperformed the broad-based BSE 500 index over the past year but outpaced it over longer horizons. 

Investment approach 

Dividend yield funds are a type of diversified equity fund. “The Securities and Exchange Board of India (Sebi) guidelines require them to invest a significant portion of their portfolio in dividend-yielding stocks. Limited exposure to non-dividend-paying stocks is also allowed,” says Mittul Kalawadia, senior fund manager, ICICI Prudential Asset Management Company (AMC). 

“We invest in a portfolio of companies that offer a higher dividend yield than the average for the benchmark,” says Amit Premchandani, fund manager, UTI Mutual Fund. These funds invest across market caps. “Their portfolios focus on dividend-paying sectors such as fast-moving consumer goods (FMCG), consumer, healthcare, utilities, information technology, and banks,” says Premchandani. 

Companies that generate strong operating cash flows, need low capital expenditure, and can therefore both pay dividends and fund growth are part of the portfolios of these funds. 

Managers also try to assess future dividend flows. “We look at the sustainability of the yield and whether it can grow,” says Kalawadia. Some fund managers focus on both dividend yield and earnings growth. UTI’s fund also invests in real estate investment trusts (Reits) and infrastructure investment trusts (Invits), which distribute the bulk of their income to unit holders. 

Downside protection 

Companies that pay high dividends offer downside protection during periods of market stress. “They tend to be less volatile. Most such companies do not face leverage issues and generate good cash flows. This allows them to deliver better risk-adjusted returns, especially during periods of market turbulence,” says Premchandani. 

Some managers cut volatility by avoiding stocks having high beta and standard deviation. 

“Dividend yield funds often perform better in a market that is moving sideways or correcting,” says Nehal Mota, cofounder and chief executive officer, Finnovate. 

Risk of slower growth 

Dividend yield funds mostly invest in mature-stage companies growing at a slower pace. 

“These funds may have lower growth potential compared to pure growth-oriented equity funds. They provide stability, 

but their upside is capped compared to mid and smallcap and growth funds,” says Mota. 

They may also lag during bull runs. “Growth stocks, which reinvest profits instead of paying dividends, typically lead 

bull rallies,” says Mota. 

Sector concentration is another risk. These funds tend to have higher exposure to public sector units and to sectors like banking, oil and gas, and utilities. 

Investors should not assume that high dividend-yielding companies will continue to provide high dividends. “Companies can change their dividend payout policy in the future, depending on their reserves,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi)-registered investment adviser and founder, SahajMoney.com. 

Who should consider them? 

These funds are suitable for investors who want equity exposure but also desire lower downside. Premchandani says they are meant for investors focused on sound risk-adjusted returns. “Retirees and conservative investors can consider dividend yield funds,” says Kumar. He adds that those seeking high-growth opp­ortunities should avoid this category. 

Key pointers 

Dividend yield funds should be part of a diversified portfolio, and should not be the sole equity exposure. Investors should not rely on them for a steady income stream. “For predictable income, use systematic withdrawal plans (SWPs),” says Mota. Check the portfolio for sector concentration. 

Kumar suggests including them in the satellite portfolio. “Allocate 10 per cent of your equ­ity portfolio to them with a horizon of at least five years,” he says.