DIVIDEND YIELD FUNDS: A hedge against market downturns

Retail investors who want to invest in equity without taking too much risk and are looking for regular income from their investments should consider investing in dividend yield funds. These thematic mutual funds invest up to 65% of the portfolio in high dividend paying stocks irrespective of the market conditions. In fact, high dividend yield companies limit downside risk, are better placed to weather economic downturns and bring stability to the portfolio.

Dividend yield shows how much a company pays out in dividends each year relative to its stock price. Most dividend-yielding stocks belong to sectors such as public sector companies, utilities, and information technology, which tend to be under-represented in most other diversified mutual fund portfolios.

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These schemes invest predominantly in stocks of dividend yielding firms with a preference for those that have a consistent track record of paying dividends at the time of investment. These schemes are mostly market cap and sector agnostic. By allocating a portion of one’s investment to dividend yield funds, investors stand to additionally benefit from decent diversification.

Experts say high dividend yield companies are generally well-placed in terms of valuation. Sreeram Ramdas, vice-president, Green Portfolio PMS, says dividend paying stocks is a hedge against market downturns. “From what we have seen and based on historical data, the risk in terms of drawdown is lesser compared to a similar non-dividend paying stock during market downturns. These stocks ensure consistent dividends, and a special dividend, if any, is always a bonus for shareholders.”

Nirav Karkera, head of research, Fisdom, says typically, these companies find themselves in the mature phase of the business life cycle, generating healthy cash flows and exhibiting favorable return on equity metrics. “When it comes to equity investments and seeking a balanced level of volatility, dividend yield funds emerge as a favourable option. Empirical evidence suggests that high dividend yielding stocks, which form the core of such funds, have historically demonstrated lower drawdowns compared to their counterparts on broader indices.”

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Such funds are ideal for moderate risk-takers eyeing steady incomes through equities. Anil Rego, founder, Right Horizons PMS, says moderate risk-takers always keep a portion of their portfolio into regular income in the form regular dividend or interest income to cover their other needs or get re-invested into markets. “In recent times, the participation of dividend yield funds/ regular income yielding investments options are becoming the eye-catching option in the market,” he says.

Protection during market volatility

High dividend-paying companies have robust cash flows and solid market positions within their respective industries. Over time, stocks of these companies have demonstrated a remarkable ability to experience limited drawdowns. Moreover, they exhibit comparably lower volatility, making them a valuable addition to diversified portfolios by offering meaningful downside protection.

During a downturn, the regular income options such as dividend income or interest pay-out help investors to mitigate their losses and provide the opportunity to convert the regular income streams into high-growth investment options at the discounted price. “The regular dividend options provide the comfort-zone, especially for senior-citizens, to participate in the equity markets,” says Rego.

Factors to consider

If you are looking to invest in a dividend yield fund, there are certain distinct factors that require careful evaluation. Focus on identifying funds that not only exhibit lower degrees of volatility empirically but also demonstrate limited portfolio turnover and a significant allocation to companies with a proven track record of strong dividend yields.

“While assessing dividend yield funds, it becomes crucial to prioritise stability and consistency. These funds should have a track record of exhibiting relatively lower levels of volatility, safeguarding investors against sudden market fluctuations and delivering risk-optimal returns,” says Karkera.

You must take a look at the sectors the fund is investing in. Ramdas says it is a misconception that only PSUs pay out a consistent dividend. “We have several small and mid-cap players who are delivering consistent dividends to its shareholders. Look at small and mid-cap space exposure through model portfolio’s or Smallcase,” he says.

Investors must note that dividend yield stocks are less liquid and there could be periods when they may underperform relative to other stocks. So, those who do not want to take too much risk should invest in a dividend yield fund that has a higher allocation to large-cap stocks.