Many profitable companies regularly distribute a portion of their profits among their shareholders through payments known as dividends. These companies are often stable and well-established, and these regular payments act as a reward for shareholders who invest in and support the company.
Investors looking for a regular income look to these dividend-paying companies to earn a steady stream without feeling the need to sell their shares. When mutual funds invest primarily in companies that have a history of paying dividends, they are known as dividend yield funds. Let’s understand what these funds are, how they work, and how investors can make the most of dividend yield on mutual funds.
What Is Dividend Yield?
The dividend yield is a ratio that tells you about how much return you can earn from your investment based solely on dividends. For a mutual fund, the dividend yield ratio is calculated by dividing a fund’s annual dividends per unit by the fund’s current unit price. For example, if one unit of a mutual fund is priced at Rs. 200 and annually it pays Rs. 2 per share to investors, one can calculate the dividend yield ratio by dividing Rs. 2 by Rs. 200 = 0.01. In other words, this particular dividend yield fund has a yield of 1%.
Investors use this ratio to gain an understanding of a dividend yield fund’s potential to generate a regular income. Notice that this ratio is inversely proportional to the current unit price of the mutual fund, so these values can seem high for dividend yield funds going down in value.
How Does Dividend Yield Work in Mutual Funds?
Dividend yield funds are a type of equity mutual fund, where fund managers invest heavily in companies with high dividend yields. Dividends are usually paid out by established companies with a history of stable earnings and strong financial performance, which is why the portfolio of such funds is dominated by blue chip stocks.
These funds use the Nifty Dividend Opportunities 50 Index as a benchmark, and fund managers select high dividend-yielding stocks by analyzing the companies within this index. The main objective of these funds is to give investors a reliable and stable income, and since the majority of the fund’s assets are invested in well-known companies, the risk associated with these investments is relatively lower compared to other types of funds within the equity category.
The dividend yield in mutual fund investments is not fixed, rather it depends on the performance of the underlying assets and market conditions. The frequency with which investors receive their dividend payments, for example, monthly, quarterly, or semi-annually, also varies from fund to fund.
Types of Dividend Mutual Funds
As mentioned previously, dividend yield funds are a sub-category of equity funds, so according to SEBI, they must invest at least 65% of their assets in equities. However, around 75% to 80% of the corpus is invested in stocks with high dividend yield in these funds. The focus is on stocks that offer shareholders high and consistent dividend payouts, as well as benefits like bonus shares or share buybacks.
These funds can also vary in approach, as they may have a value focus, be primarily growth-oriented, or they can combine growth and value. Even within this sub-category, there can be dividend funds with varying risk levels. For example, thematic dividend funds invest more than 80% of their assets in stocks of companies tied to a common theme, like pharmaceuticals. These types of funds thus carry significant risk in the short term.
Very conservative investors can also explore the option of income funds. Just like dividend funds, income funds help investors earn a regular income. The main differences are that income funds are a sub-category of debt funds, so the fund invests primarily in debt securities like bonds and money market instruments, and that the income earned is through interest and not dividend-paying stocks.
How to Choose the Best Dividend Yield Mutual Funds
The basic steps in selecting a suitable dividend-yielding mutual fund are largely the same as selecting any mutual fund, with a few additions:
1. Define your financial goals and make them as specific as you can. Generally, dividend-yielding funds are preferred by individuals whose main objective is to generate a regular income, such as retirees.
2. Assess your risk tolerance and investment horizon, as you need to make sure the fund aligns with your financial goals and comfort level. For example, if you stay invested for the mid to long term, you might prefer equity funds to generate the regular income, while conservative investors can fall back on the more stable income funds to generate their passive income stream.
3. Analyze the fund’s qualitative and quantitative characteristics, such as the fund house’s AUM, the scheme’s AUM, the manager’s track record, past returns, risk-adjusted returns, exit loads, and others. Importantly, you should check the fund’s dividend yield history and how consistently they have paid them out. Generally, the best dividend mutual funds are those that show consistency rather than those with high but irregular dividend payouts.
Benefits of Investing in Dividend Yield Mutual Funds
Investing in dividend-yielding mutual funds is beneficial mainly for investors looking to generate a regular income. Here are some benefits such funds offer:
1. Even though the main goal of such funds is to provide a steady income, investing in equities can also help investors grow their capital in the long term.
2. Companies that pay steady dividends are often well-established and have large market capitalization. Such companies are not as badly affected by market volatility as smaller, more growth-focused companies. Their strong financial foundation gives them the ability to maintain stable earnings, which makes it possible for them to continue paying dividends even during downturns. That’s why dividend yield funds perform better in bearish conditions compared to riskier equity funds like small and mid-cap funds.
3. Dividend yield funds offer built-in diversification, which can significantly lower the risk associated with your investment. One can individually select high dividend yield stocks, but this approach can be tedious and time-consuming, and it often lacks the same level of diversification and professional management that a dividend yield fund provides.
4. Direct investment in dividend-paying stocks also attracts higher taxes. On the other hand, the dividend yield in mutual fund investments is taxed at a lower rate, helping you save more of your hard-earned money.
Conclusion
Dividend yield funds are a type of equity mutual fund where the majority of the assets are invested in the stocks of companies with high dividend payouts. Since these companies are financially stable, dividend yield funds focus on large-cap or blue-chip stocks. These companies have a proven track record of generating consistent profits, which is why they can withstand market volatility to some degree and reward shareholders with regular dividend payments.
These funds are preferred by investors looking to earn a steady income while appreciating their capital in the long term. The dividend yield on mutual funds is not fixed, so investors should assess a fund’s consistency before investing. They should also make sure to align their financial goals and risk appetite with the fund’s to ensure a suitable match.
