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In volatile markets, dividend yield funds may perform better than stocks

Though investing on your own may help you customise the portfolio and decide on high yield stocks, the mutual fund route brings in better post-tax returns.

July 19, 2022 / 09:40 AM IST

When markets turn volatile, dividend yield stocks—those that pay shareholders a share of the profit earned—or mutual fund schemes that invest in such stocks turn popular.

Over the last one year, investors have been buying both private and public sector enterprise companies’ stocks quoting at attractive yields. According to Value Research, dividend yield funds and PSU equity funds gave 3.19 percent and 7.58 percent returns over the year ended 13 July, 2022. Flexicap funds over the same period gave 0.12 percent returns.

Why dividend yield?

Before we get into how to go about investing in dividend yield stocks, let’s understand what it means and why investors are so keen to invest in them. Dividend yield is arrived at by dividing the per-share dividend amount by the share price. So if a stock quotes at Rs 100 and it pays out a dividend of Rs 2, then the dividend yield works out to 2 percent. The higher the dividend yield, the better it is.

An investor may prefer to buy a stock offering 5 percent dividend yield over a bond offering a similar rate of interest. Though the stock price may turn volatile and the dividend is not assured, it also offers a chance to participate in probable future increase in earnings, which a bond does not.

Such investing is not just about buying a stock quoting at high dividend yield. There are enough screeners available online offering a list of these kinds of stocks. But there may be a few value traps.

Investors have to exclude companies offering one-time special dividends, companies with questionable fundamentals, and companies that have not been consistent in paying dividends.

Ravi Kumar TV, founder of Bengaluru-based Gaining Ground Investment Services, says, “Investors need a clear understanding of the growth phase of the company. Buying a set of stocks only relying on past dividend yields may not work.”

A complex macroeconomic situation further adds to the challenges. The last couple of years have been especially tough for investors. Low interest rates in CY21 saw many investors hunt for assets offering better ‘yields’. That for some meant adding dividend yield stocks to their portfolios. The situation has changed now as interest rates have risen. This has led to stock prices of many companies with poor fundamentals to correct sizeably. Equity investors have to look for companies with strong balance sheets and consistent cash generation abilities. And consistent dividend-paying stocks fit the bill.

However, there remains the challenge of picking the right dividend yield stocks.


Mutual fund route

The need for a professionally managed stock portfolio designed using the dividend yield principle has seen investors turn to mutual funds.

There are eight such schemes managing a combined Rs 9,144 crore in assets as on June 30, 2022. These schemes offer diversified portfolios of stocks and invest at least 65 percent of the funds in dividend yielding stocks. Over the five- and 10-year period ended July 13, these schemes gave 9.71 percent and 12.81 percent returns, respectively. Compare this with 9.54 percent and 13.89 percent given by flexicap funds over the same time frame and these funds look unattractive.

But an equity investor should never lose track of volatility while looking at performance numbers. Over the three years ended June 30, dividend yield schemes on average registered standard deviation of 19.65 compared to 21.48 by flexicap funds. Lower standard deviation means lower volatility.

“Better to route the dividend yield stocks investments through equity mutual funds. These schemes can offer double-digit returns over a long period of time and allocating some money to them along with other growth-focused equity schemes can bring down portfolio volatility,” says Ravi Kumar.

But Vikas Gupta, founder and chief strategist, Omniscience Capital, has a different take. While investing for a good yield, you need to build a well-researched concentrated portfolio of around 10-12 stocks. Going beyond this generally brings down the yield. Since mutual fund schemes’ diversified portfolios do not offer good yields, they are best ignored if you are keen on income from dividend yield in line with high quality bonds, he believes.

“Dividend yield funds can only be looked at if you are keen on a less volatile, value-focused portfolio instead of high yield,” he says.

Don’t forget tax tangle

Though investing on your own may help you customise the portfolio and decide on high yield stocks, the mutual fund route brings in better post-tax returns. When you receive dividends from the stocks held by you, they get added to your income and are taxed as per the slab rate. But if you invest in an equity mutual fund, the scheme receives the dividends and reinvests them. Since a mutual fund is a pass-through vehicle, it does not pay tax. You are supposed to pay tax only when you sell units of mutual fund schemes and book gains or you receive dividends from the mutual fund.

Balwant Jain, a Mumbai-based chartered accountant, says, “Individuals in high income tax brackets should ideally invest in the growth option of the dividend yield fund. Individuals earning less than Rs 5 lakh per year can either directly invest in stocks or can invest in the dividend option of the dividend yield fund to avail tax rebate under Section 87A.”

If you have invested in the growth option of a dividend yield fund, you can sell units after one year to the extent of cash flow you need. Such gains will be taxed as long-term capital gains (LTCG) and taxed at 10 percent only if the amount exceeds Rs 1 lakh. Amounts up to Rs 1 lakh in a financial year are exempt from LTCG tax.

Though equities reward investors in the long run, they can be volatile in the short term. Hence, stagger your investments in stocks or equity mutual funds and gradually build your equity portfolio.
Nikhil Walavalkar
first published: Jul 18, 2022 07:20 am