How Appealing Are Dividend Yield Funds?

In an overvalued market, high-dividend yield stocks can offer better value. High dividends may suggest that a stock is undervalued, particularly if the company has a consistent history of paying dividends. The article presents a detailed overview of this scenario 

In early August, the equity market, represented by the Nifty, soared to the 25,000 mark, while the BSE Sensex surpassed 82,000. Over the past year, the equity market has experienced substantial gains, with the market capitalisation of BSE-listed companies increasing by nearly 50 per cent. Such rapid growth in a short period can lead to elevated valuations. Currently, Nifty 50’s price-toearnings (PE) ratio stands at approximately 24 times, which is higher than its long-term average. 

In an overvalued market, high-dividend yield stocks can offer better value. High dividends may suggest that a stock is undervalued, particularly if the company has a consistent history of paying dividends. This makes them appealing to value investors seeking less risky investments. Historically, high-dividend yield stocks have been less volatile than growth stocks. Companies that pay high dividends are typically more established and financially stable, which reduces the risk of significant price swings. The consistent income they provide can help cushion against market downturns and stabilise a portfolio’s overall performance. 

What Are Dividend Yield Funds?
Investing in equities can be daunting for many investors due to the challenge of identifying good stocks. However, you can still earn dividends without the risks and time commitment of direct equity investment by investing in dividend yield funds. Let’s explore what dividend yield funds are and how they work. Dividend yield mutual funds invest in companies with strong financials and excellent cash flow, as these companies are more likely to declare dividends. Fund houses typically select ‘high dividend’ companies by comparing their dividend yields with benchmark indices like the Sensex or Nifty 50. 

For example, with the current dividend yield of Nifty 50 at around 1.2 per cent, a dividend yield fund based on this index would favour companies with dividend yields above 1.25 per cent. As per the guidelines prescribed by Securities and Exchange Board of India (SEBI), dividend yield mutual funds are required to allocate at least 65 per cent of their portfolio from dividend-yielding stocks. Generally, dividend yield funds allocate about 75 per cent to 80 per cent of their capital to high-dividend companies, while the remaining portion is invested in stocks that the fund manager believes have high return potential. 

This strategy is based on the belief that companies with lowdividend yields or those that do not pay dividends can still offer good returns if they are undervalued and have strong fundamentals. Additionally, this approach provides diversification for investors. High-dividend stocks are usually from well-established businesses that opt to distribute profits to shareholders instead of reinvesting them. These companies are often found in the financials, energy, utilities and industrials sectors. 

Performance of Dividend Yield Funds
The average return of the dividend yield funds has always been in the top two quartiles or above median in all timeframes. In the last one year, on an average, dividend yield funds have generated return of 48.94 per cent – second only to the PSU theme that generated best returns in the last one year. Even when we take a longer duration of 10 years, it has generated annualised return of 16.2 per cent, better than many other categories, including Large-Cap-dedicated funds. 

In absolute terms, all the dividend yield funds have generated return of more than 100 per cent of their NAV. Even in five years, the funds have generated better returns. ICICI Prudential Dividend Yield Equity Fund, one of the best performing in the category, gave 27.73 per cent return in the last five years or 340 per cent in absolute terms. Templeton India Equity Income Fund Direct Growth in the same period gave 28.46 per cent, which works out to 350 per cent in absolute terms. 

The following graph shows the average performance of different categories of mutual funds in different periods. 

There are about 10 active dividend yield mutual funds currently out of which eight funds have completed more than a year. In the last 10 years, on an average, dividend yield funds have outperformed Nifty 50 in eight years. There were only two years when the dividend yield funds underperformed – 2018 and 2019. This was primarily due to the lopsided performance of Nifty 50, as Bajaj Twins and HDFC Twins generated better returns and these might not have been a part of many funds as they did not have a better dividend yield. 

The good performance of dividend yield funds could be a sign that investors are seeking stability in a volatile market. The AUM of dividend yield funds as on March 31, 2024 was recorded at Rs 23,914 crore. 

Suitability of Dividend Yield Funds
Dividend-paying companies are often larger firms that we discussed earlier whose stocks are popular holdings among large-cap mutual funds. As a result, investors who own large-cap funds may already hold a sizeable position in dividend stocks. The following graph shows the average holdings of the funds based on market capitalisation.

We can clearly see that on an average these funds hold 61.45 per cent in large-caps followed by Small-Caps and finally the Mid-Caps. Hence, if someone is not holding any large-cap funds in his portfolio, he may consider adding this to the portfolio. That doesn’t mean investors shouldn’t add a dividend fund to their portfolios if they already have exposure to large-company stocks. However, investors should be aware of what adding a dividend stock fund may do to the complexion of their current portfolio mix. These funds also show a lower volatility. Hence, investors who are averse to the high volatility often associated with pure equity investments may find dividend yield funds more suitable. These funds tend to invest in financially stable companies, which can help mitigate some of the market’s ups and downs. 

Conclusion
The current geopolitical tension and likely hard landing in world’s largest economy may make things worse for the equity market globally. We may see increase in volatility across the equity market. Against this background, dividend yield funds present a compelling investment option for those seeking stable returns and reduced volatility within the equity market. By targeting companies known for regularly declaring dividends, these funds offer exposure to high dividend-paying, generally stable, and well-established companies through mutual funds. Furthermore, dividend yield funds enhance portfolio diversification by including a broad range of companies across various sectors. This diversification helps investors manage risk more effectively and navigate market uncertainties with greater confidence.