Investing in Dividend Yield Funds – Is It a Sensible Choice?

The central bank estimates inflation will remain at 5.1% in FY22; and, it aims to keep inflation within the target band of 2%-6%, going forward.

Since there is ample liquidity in the system and the credit offtake is still relatively low, interest rates on deposits are likely to remain unchanged, at least in the foreseeable future. At present, leading Indian banks have been offering less than 5% interest on 1-year deposits.

Negative inflation-adjusted interest rates are making conservative investors jittery. Raw deals like these often pressurise them to steer towards riskier asset classes such as equities, which can be disadvantageous, particularly at a time when valuations are expensive. In turn, this makes equity valuations more expensive; and the margin of safety that's usually available to investors, drops substantially.

Interestingly, some oil marketing companies declared impressive dividends recently for the FY21 (as on March 31). On the stock prices prevailing at the time of dividend declaration, their dividend yields were much higher than the interest rates offered by most leading Indian banks on 1-year deposits.

Given the current scenario, an indepth discussion on dividend yield funds would be beneficial to you, the investor.

Fact is, negative real interest rates are indeed affecting the disciplined savers like you.

But the pertinent question is, can stocks with higher dividend yields or mutual fund schemes investing in such funds make for a good investment alternative?

Let's take a look at the performance of Nifty Dividend Opportunities 50 and its attributes. Primarily because dividend yield funds typically use that as a benchmark to measure their performance.

According to the the NSE data in the graph above, as on June 04, 2021, Nifty Dividend Opportunities 50 traded at the Price-to-Earnings (PE) ratio of 18.84% and its dividend yield ratio was 2.99%. On the other hand, Nifty 50 traded at a PE of 29.06% and its dividend yield ratio was 1.07%.

As you may be aware, the constituents of Nifty Dividend Opportunities 50 are selected from within the top 300 companies based on the average free-float market capitalization. And as per the factsheet on May 31, 2021, its beta value (as compared to Nifty 50) was 0.72 and 0.79 over the last one year and 5 years, respectively.

This indicates that high dividend companies are chosen from the universe of liquid stocks and low beta. It further suggests that the Nifty Dividend Opportunities 50 exposes investors to lower risks, as compared to the Nifty 50 companies.

Here is a performance track record of dividend yield funds across time periods:

From the data table, we can infer that the performance of most dividend yield funds has been better than that of Nifty Dividend opportunities 50-TRI across time frames, specifically over the last two years. But it's crucial to see whether the dividend yields and PE ratios of these funds are in line with that of their benchmark index.

​Deeper analysis reveals that PE and PB ratios of dividend yield funds have been higher than that of their benchmark index. But, in comparison, the dividend yields have been lower. This is an indication that the fund houses don't solely rely entirely on value stocks with high dividend yield, but allocate resources to relatively expensive growth stocks as well. In other words, although the dividend yield funds have outperformed, their risk profiles and attributes differ considerably from those of the Nifty Dividend Opportunities 50 index.

Dividend Yield Funds may sound attractive for those looking to generate a higher dividend yield income. However, these funds may not always work in your favour. Some dividend yield funds are not true to their name, as they still carry a higher flavour of growth stocks and, thus, earn a lower dividend yield.

Advisably, you need to consider your investment objective and preferences before diving into dividend yield funds. A small allocation to value style funds may offer you a mix of high dividend yielding stocks and stocks available at attractive valuations; as well as have the potential to offer decent capital appreciation in the long run.

When you invest in equity mutual funds, you must carefully weigh the risks and rewards. Bear in mind, getting swayed by a get-quick-rich pitch and tall claims in the pursuit of getting wealthier is not the right approach towards investments, patience and discipline are.

As an investor, it's important to be cognizant of the right kind of allocation for your portfolio and the fund's quantitative and qualitative parameters. When investing in mutual funds, begin by making responsible choices in alignment with your financial goals and time horizon so you can benefit from wise investment decisions and achieve your envisioned goals.

Refer to all scheme related documents thoroughly to get a better sense of the scheme objective and how it will be achieved-investment strategy, asset allocation, etc. This will help you fully understand the various scheme specific risk factors that could affect its performance and gives you the chance to select funds most suitable to your risk profile.

You should analyse equity mutual fund schemes based on various criteria such as:

1. Scheme performance

2. Risk-return ratios

3. Various qualitative parameters

4. Portfolio characteristics

If you want to generate better returns on your equity mutual fund portfolio, then here's a time-tested secret strategy that successful investors usually adopt-"Core & Satellite".

The term 'Core' applies to the more stable, long-term holdings of the portfolio, while the term 'Satellite' applies to the strategic portion that would help push up the overall returns of the portfolio, amidst the prevailing market conditions.

By wisely structuring and timely reviewing the Core and Satellite portions and the holdings therein, you would be able to add stability to the portfolio and at the same time strategically boost your portfolio returns.

The 'Core' holding should comprise around 60% of your equity mutual fund portfolio and consist of a large-cap fund, flexi-cap fund, and a value style fund. Whereas, the 'Satellite' holdings of the portfolio can be around 40% comprising of a mid-cap fund, large & mid-cap fund, and an aggressive hybrid fund.

The benefits of adopting 'Core & Satellite' approach while investing in equity mutual funds are as follows:

1. Facilitates optimal diversification among equity mutual fund schemes

2. Enables you to benefit from a variety of investment styles and strategies

3. Reduces the need to frequently churn your entire portfolio

4. Reduces the level of risk in your portfolio

5. Creates wealth cushioning the downside

6. Helps you potentially outperform the market

Note, the Core & Satellite investment strategy may work for you in 2021 and beyond.

Warm Regards,
Vivek Chaurasia
Editor, FundSelect

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