The USP of dividend yield funds

Rohit Shimpi, who will be the fund manager for SBI Dividend Yield Fund, says this is a much larger fund category globally, particularly in markets like the US and Europe.

For example, the Vanguard High Dividend Yield ETF that trades on US exchanges has assets under management (AUM) of $50 billion, or ₹4 trillion at current exchange rates. The SPDR S&P Euro Dividend Aristocrats UCITS ETF, which is listed on the German exchange, has AUM of €1,038 million, or ₹9,102 crore.

At present, there are eight dividend yield funds in India with combined AUM of ₹10,414 crore.

How these funds work

A portfolio of a dividend yield fund comprises of stocks that have a consistent track record of dividend payouts to their shareholders. The dividend yield of a company is the dividend paid by the firm as a percentage of its stock price. For example, if a company has paid a dividend of ₹30 in a financial year (interim dividend of ₹5 and final dividend of ₹25) and the company’s stock price is ₹600, then its dividend yield is 5%.

Both Nifty 50 and Nifty 500 had a dividend yield of 1.4% as of 31 January, while that of Nifty Dividend Opportunities 50 Index was 3.6%.

Fund managers also look for the earnings growth potential of a stock, but consistency of dividend payouts usually takes precedence.

Dividend yield funds invest in mature businesses that have the ability to generate free cash flows consistently. Free cash flow is an important parameter for dividend yield funds, as companies can distribute dividends from the cash available on their balance-sheets. Free cash flow is defined as the cash that remains with a company after meeting its financial obligations — operational and capital expenditure —in a financial year. Businesses with high free cash flows tend to also be cash-rich.

The top sectors that these funds have in their portfolios are Information Technology (IT), banks, fast moving consumer goods (FMCG) and power utilities (see table). Several companies in these sectors run mature businesses with cash-rich balance-sheets, which is why these sectors have sizeable exposures in these funds.

Apart from a large cap tilt, these funds also take some exposure to mid and small cap stocks, offering higher growth potential.

For example, Aditya Birla Sun Life Dividend Yield Fund has 17.7% exposure to mid cap stocks and 25.2% to small cap stocks. UTI Dividend Yield Fund has 14.9% exposure to mid cap stocks and 15.4% to small cap stocks.

Among the existing dividend yield funds, Franklin India’s Templeton India Equity Income Fund is unique as it has some exposure to stocks listed on foreign exchanges too.

Past performance

Dividend yield funds have outperformed flexi cap funds in terms of recent performance. In a three-year period, dividend yield funds have delivered category average returns of 18.8% compounded annual growth rate (CAGR) versus 14% CAGR returns delivered by flexi cap funds.

But this can be attributed to market favouring value stocks over growth stocks, which has indirectly helped dividend yield stocks. These stocks typically trade at lower price-to-earnings (P/E) multiples compared to growth stocks, which tend to trade at relatively high valuation multiples.

“In the recent period, value stocks have outperformed growth stocks. Value stocks had massively underperformed in the previous decade. Hence, some rebound in these stocks was anticipated," says Amar Ranu, head of investment products and advisory, Anand Rathi Shares and Stock Brokers.

Anish Teli, managing director at QED Capital Advisors, says equity market has in the last couple of years largely remained flat and has been volatile too. “On the contrary, due to the inherent nature of dividend yield stocks, the category has done well as these stocks are less prone to volatility and uncertainty in the market. Due to this, dividend yield funds have done well relative to flexi cap funds," he says.

During volatile periods, dividend-yielding stocks may fall less. For example, when Nifty 50 Index corrected by 38% during the post-covid correction in 2020 (between 14 Jan 2020 and 23 March 2020), the Nifty Dividend Opportunities 50 Index fell by 33%.

During market rallies though, these stocks may underperform as the preference is for high-growth companies over value stocks during such periods.

For example, between 23 March 2020 and 18 October 2021, when Nifty 50 Index rallied 142%, Nifty Dividend Opportunities 50 Index was up 128%.

An analysis of five-year CAGR returns rolled from 21 February 2018 shows that dividend yield funds have underperformed flexi cap funds with average CAGR returns of 10.7% against 12.1% CAGR returns delivered by flexi cap funds.

Dividend yield vs value

While similar to value stocks in many ways, the stock and sector selection differs in the focus on free cash flows.

“While there are similarities, there are differences too. For example, sectors such as FMCG are unlikely to have an overweight in value category, as these companies tend to trade at relatively high P/E multiples," Shimpi says.

“The focus in a dividend yield strategy is to look for companies offering free cash flows. In the value category, the strategy might be to look for companies where free cash flow may not be great at the moment, but there is inherent value. These funds may get into sectors such as construction, real estate, etc.," he adds.

From volatility perspective, dividend yield strategy is likely to be less volatile than value strategy.

For example, Nifty Dividend Opportunities 50 Index had standard deviation of 15.8 in 1-year period against standard deviation of 16.6 of Nifty 50 Value 20 Index. Over 5-year period, Nifty Dividend Opportunities 50 Index had standard deviation of 17.2, against standard deviation of 17.9 of Nifty 50 Value 30 Index.

In dividend yield funds, fund managers also look for stocks where dividends can grow over time.

Should you invest?

While the focus is on dividend yield, these funds can also take advantage of the stock’s growth potential.

As these strategies tend to limit downside during market correction, they can make for a less volatile alternative for an investor.

At the same time, dividend yield funds tend to participate less in market upsides compared to diversified equity funds over the long term. There can be periods of outperformance when market preference shifts towards value stocks, as seen in recent periods.

When it comes to investing in equity markets, a long-term investment horizon can reduce the impact of market volatility.

An equity investor with a long-term investment horizon, can look for options in a diversified fund category like flexi caps. Flexi cap funds are not constrained by any strategy—dividend yield, value or growth, or even any market cap limits. Fund managers can include any stock or sector in their portfolio that can help the fund deliver healthy returns.

There are flexi cap funds out there that have demonstrated ability to manage volatility during market corrections.

However, dividend yield funds may do well in the near term. “Considering the recent bouts of turbulence in markets in the last few months, with limited probability of any surprises on the upside, one can expect the near- term to remain choppy for broader markets. Dividend yield funds can be expected to hold up well during the period," points out Alekh Yadav, head of investment products, Sanctum Wealth.

Such funds can be part of an investor’s satellite allocation or tactical allocation, but diversified equity funds should still be a part of an investor’s core portfolio.