WHEN YOU CALCULATE returns from equity investment, you must take into consideration two sources of returns. One, the return from an appreciation in price, and two, the revenue generated from dividend income. Simply put:
Equity returns = capital appreciation + dividend
Inarguably, the capital appreciates or price appreciates element holds maximum sway and has a large impact on your total returns from equity investments. However, the dividend element should not be ignored. A lot of well-established companies in India regularly pay dividends, and you can create a small source of dividend income for yourself by investing in these companies. If direct equity investing is not your cup of tea, then you can simply consider investing in a dividend yield fund.
What is a dividend yield fund?
A dividend yield fund is a type of equity fund that invests in stocks of companies that have a high dividend yield and have historically been regularly paying dividends. Generally, a dividend yield fund invests approximately 70-80 per cent of its corpus in stocks that have a high dividend yield (historical dividend yield should be higher than market dividend yield) and the balance they invest in other stocks. It is important to note that the criteria for selection are not high dividend but high dividend yield. Before we move on to understanding how a dividend yield fund can add value to your investment portfolio, let us first understand the difference between dividend and dividend yield.
A dividend refers to a sum of money that a company pays to its shareholders from its profits. Two factors need to come together for a company to pay dividends. One, it should be making profits and should have surplus cash. And, two, it should choose to pay out the profits rather than reinvest it back in the business.
Dividend yield is the dividend expressed as a percentage of the share price of the company. It is usually expressed annually and it tells you what percentage of a company’s share price is paid out in dividends.
More than a bear market friend
What dividend funds essentially do is that they reduce the volatility of your investment portfolio. Now, historically, companies that have consistently declared dividends are those that are profitable and well-established. They have weathered multiple market cycles and are now in a position to generate profits and redistribute them amongst shareholders. Exposure to such companies will add stability to your equity portfolio and enhance returns in the form of dividends. However, while talking about returns, it is also important to understand that since these companies are no longer in a high growth phase, they are unlikely to generate exponentially high returns. Another thing about dividend yield funds is that they invest in companies that have a high dividend yield, i.e., the dividend relative to the current share price is high. Inevitably, they end up becoming value funds since the stock price relative to the dividend is low. While value funds can underperform for extended periods, over an entire economic cycle, they can also generate potentially good returns. Thus, when you invest in a dividend yield fund, you must have a long-term investment horizon.
More importantly, know why you want to invest in a dividend yield fund. If it is just for dividend income, exponential returns, or short-term gains then it might not be the right investment for you. On the other hand, if you have a long-term investment horizon and are looking for stability and the potential for consistent income and good returns over a longer period, then a dividend yield fund might just be the solution for you. To that extent, they can be a good addition to every kind of portfolio. An important thing to remember is that dividend yield funds are not mandated to pay out dividends. Thus, when you invest in a dividend yield mutual fund you must ensure that the fund has a decent sized corpus, low historical volatility, consistent dividend payout history, and low expense ratio. For example, ICICI Prudential and Templeton are some of the top-performing funds in this category.
At the end of the day, all investments that you make must be well-aligned with your asset allocation strategy, adhere to your risk and investment time horizon constraints, and have the potential to generate the desired returns.
The writer is co-founder, Money Tree Services.