Dividend yield funds: Weak track record, not ideal for long-term investors

Since consistent dividends are generally announced by companies with a fair degree of profitability and steady cashflows, they are deemed more trustworthy.

Six mutual funds offer schemes focused on stocks offering attractive dividend yield. They manage assets worth Rs 3282 crore as on  March 31, 2020.

Each mutual fund clearly defines attractive dividend yield for investments.

Templeton India Equity Income Fund and Aditya Birla Sun Life Dividend Yield Fund invest some portion of their assets in the shares of companies listed overseas, and available at an attractive dividend yield.

Consistently high dividend paying companies typically do not have high capital expenditure requirements. Investing in such companies can make returns less volatile, as richly valued growth companies may see more downside as growth disappears. “Regular dividend paying companies tend to be stable businesses generating regular cash flows and the portfolio is expected to generate moderate long-term returns,” says Ravi Gopalakrishnan, head – equities, Principal Asset Management.

Dividend yield funds underperform

Over the past five years dividend yield funds have given 3.42 per cent returns compared to the 4.89 per cent delivered by the BSE 500 TRI, according to data from Valueresearch.

These funds have outperformed the BSE 500 TRI in five out of 11 years including CY2020. “Though all dividend yield funds start with the same yardstick of attractive dividend yield, the portfolio construction decides how they perform,” says Vidya Bala, co-founder and head-research and products, Prime Investor. For example, sizeable exposure to information technology and consumer goods in line with Nifty Dividend Opportunities 50 Index has helped Principal Dividend Yield Fund outperform the category average. ICICI Prudential dividend yield fund, with highest exposure to the energy sector, underperformed.

Reasons for lagging behind

“Dividend yield is a defensive strategy and provides returns with lower volatility. Equity markets are generally considered as growth-oriented and such a strategy may tend to underperform other equity funds during some parts of the market cycle,” says Ravi of Principal AMC. He finds it inappropriate to compare the performance of these funds to other categories of funds given the differences in the risk-return profile of the funds.

Since dividend yield funds focus on valuations of stocks, they too follow a value investing strategy in a way. Dividend yield schemes with sizeable exposure to consumption stocks – which generally offer quality, but at rich valuations – helped contain downsides in these challenging times.  If the cycle turns in favour of value-investing,  then investors may benefit.

Not the lone investment criterion

Dividend yield can be one of the factors to decide if a stock is attractive. However, relying solely on it can result in loss of capital. For example, stocks of public sector undertakings pay regular dividends and are available at attractive dividend yield. However, the stock prices of these entities almost always remain under pressure, given that they mostly operate in heavily regulated segments and face considerable government oversight.

As the corporate profitability comes under pressure, many companies may want to conserve cash. In such cases, dividends may not be declared or could be curtailed. As the dividends are taxed in the hands of the investors (and promoters) at their slab rates since April 1, 2020, promoters may choose not to declare dividends at all and instead prefer to take the buyback route.

What should you do?

“There is no compelling reason to choose a dividend yield fund over a multi-cap scheme,” says Srikanth Bhagavat, MD and Principal advisor, Hexagon Capital Advisors. If you expect the market to bounce back in near term, you are better off investing in regular multi-cap funds.

However dividend yield funds may work in bear markets. “Investors should consider dividend yield funds in a bear market,” says Ravi Kumar TV, founder of Gaining Ground Investment Services. “In bull markets, these funds tend to underperform the growth oriented equity funds. Dividend yield funds can also part of long term portfolios of conservative investors,” he adds.

Given that these finds have tended to underperform across short and long-terms, investors may be better off going with regular diversified schemes of the multi-cap and other varieties based on their risk appetite. These diversified funds would have greater flexibility for investing in a blend of value, growth and expensive quality stocks depending in the market situation, rather than being restricted by a dividend yield mandate.