Last week, in this column, we explained how mutual funds pay dividends. We had mentioned how mutual funds don’t have to pay dividends (and can’t, for that matter) unless they have a distributable surplus. A natural assumption that follows is that dividend yield funds are at least those that pay regular dividends, even if one were to go only by their name.
On the contrary, a dividend yield fund is under no obligation to pay dividends, name notwithstanding. The name defines the fund’s strategy more than its dividend-paying ability. 
What they do
Let’s get the definition of dividend yield understood first. Dividend yield is the ratio of the past dividend paid per share to its market price. Dividend includes final and interim dividend. A stock can be one that pays good dividends every year, but the stock’s price can be high. To ensure that the asking price for this stable dividend is not too much, the dividend yield comes into play.
A dividend yield fund puts the majority of its portfolio in high dividend-yield stocks. There are two points to understand in this definition. The first is that the fund does not put its entire portfolio in stocks that are good dividend payers; a part of the portfolio will go into any stock where the fund manager sees potential. Tata Dividend Yield, for example has to put 70% or above in high dividend yield stocks. HSBC Dividend Yield fund has to put 65% and above in high dividend stocks. If the stocks outside the dividend yield criteria don’t pay out dividends, it will reduce the amount of distributable surplus the fund may have had, had it put the entire portfolio in high dividend payers.
The second point is with respect to ‘high dividend yields’. The definition of what ‘high’ is varies with funds. UTI Dividend Yield and ICICI Prudential Dividend Yield link it to the Nifty 50, meaning that if a stock’s dividend yield is more than the Nifty 50’s dividend yield, it is a high dividend yield stock. Tata Dividend Yield links it to the Sensex. Principal Dividend Yield links it to the Nifty Dividend Opportunities index. BNP Paribas Dividend Yield simply states that the stock’s yield should be above 0.5%.
Each fund, therefore, has a different basket of stocks in which it can invest. The Nifty 50 dividend yield is at 1.37 times currently, the Nifty Dividend Opportunities index is at 2.9 times, the Sensex is at 1.5 times, the BSE 500 is at 1.2 times. The dividend yield itself changes as and when dividend payments are declared and stock prices move. In the listed universe, the dividend yield ranges from 0.01 to 20.88. Given the relatively lower dividend yield cut-off, the number of stocks to invest in is substantial. A fund may thus wind up holding a ‘high’ dividend yield stock simply because it’s higher than the benchmark, but which actually may not pay high dividends.
More strategy, less dividend
So why would a fund then look to dividend yields? Because a dividend yield strategy is a tool to identify value stocks. A stock whose dividend yield is high is because its price is low.
If a company is able to pay out good dividends steadily through the years, measured by the dividend payout as a proportion to profits, it means that it is a stable company. It means that the company is cash-rich, it is able to balance reinvestment of profits for growth and payment of dividend, it is not short-changing its investors, it is established, and it is strong.
For such a company, sometimes it’s stock price can be low because the market does not prefer it or has not noticed them yet. At such times, the stock price is low while the dividend pay-out is still high. That means it had a high dividend yield and also means there is value in the stock (as price is low). A dividend yield strategy therefore translates into a value-based one. Because they are value funds, they also contain downsides better, 2008 and 2011 being testament to this. The dividend income also compensates the stock price decline to an extent. The volatility of dividend yield funds, on an average, is lower than that of both diversified and large-cap categories.
Dividend yield funds follow the usual parameters to filter out stocks. Blindly selecting high dividend yield stocks may wind up in it investing in poor quality stocks. Consistency in dividend payments, its growth prospects, and fundamentals are also considered.
A dividend yield fund has more to do with identifying value stocks than paying high dividend. It has no obligation to pay dividend. If stock prices crash, it will squeeze the fund’s distributable surplus and may render it unable to pay dividends.
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Elsewhere in your advice columns you have recommended that encashing units from a growth version of a fund is better than relying on income versions of equity funds when regular income is required. However, would the income version of dividend yield funds with a strong record of paying dividends regularly not be the safer option and cheaper option, after all dividends are paid by the MF from cash flow of dividends and income received and sales of units where required?
Hi,
The argument for preferring growth over dividend holds good for all mutual funds, including dividend yield funds. Dividend yield is a way to identify value stocks – it is an investment strategy. The dividend from the stocks held is an added income, that’s all. The primary aim of a dividend yield fund is not to provide dividends – it is to beat the market while keeping volatility down. Funds do not put their entire portfolio in high dividend yield stocks, nor do they have a uniform definition of what high dividend yield is. This gives them access to a large universe of stocks, making them quite diversified. Their strategy makes them less volatile than other equity funds, but they remain an equity fund at the end of the day. A good dividend yield fund will deliver market-plus returns over time, like any other good equity fund.
Even for a dividend yield fund, dividends are not uniform or steady. Dividend is a function of distributable surplus, which is always changing. If the market crashes, there is less distributable surplus for all funds, including dividend yield funds. A detailed explanation on where dividends come from is here. Though a dividend yield fund may be regular in dividend frequency, it cannot be regular in dividend amount. If you need regular income, even the dividend plan of a dividend yield fund may not always satisfy you.
When you take the dividend option, whatever the fund, you are booking profits in your investments from time to time. When you do this, you hurt compounding. The compounding benefit in the growth option holds good for dividend yield funds and all other funds. Dividend plan is not ‘cheaper’ than a growth plan. There is no concept of cheap or expensive between funds or plans. This post will tell you why growth is preferable. If you want to be safe in your investments, it needs to be addressed through asset/category allocation more than dividend-growth.
Thanks,
Bhavana
Elsewhere in your advice columns you have recommended that encashing units from a growth version of a fund is better than relying on income versions of equity funds when regular income is required. However, would the income version of dividend yield funds with a strong record of paying dividends regularly not be the safer option and cheaper option, after all dividends are paid by the MF from cash flow of dividends and income received and sales of units where required?
Hi,
The argument for preferring growth over dividend holds good for all mutual funds, including dividend yield funds. Dividend yield is a way to identify value stocks – it is an investment strategy. The dividend from the stocks held is an added income, that’s all. The primary aim of a dividend yield fund is not to provide dividends – it is to beat the market while keeping volatility down. Funds do not put their entire portfolio in high dividend yield stocks, nor do they have a uniform definition of what high dividend yield is. This gives them access to a large universe of stocks, making them quite diversified. Their strategy makes them less volatile than other equity funds, but they remain an equity fund at the end of the day. A good dividend yield fund will deliver market-plus returns over time, like any other good equity fund.
Even for a dividend yield fund, dividends are not uniform or steady. Dividend is a function of distributable surplus, which is always changing. If the market crashes, there is less distributable surplus for all funds, including dividend yield funds. A detailed explanation on where dividends come from is here. Though a dividend yield fund may be regular in dividend frequency, it cannot be regular in dividend amount. If you need regular income, even the dividend plan of a dividend yield fund may not always satisfy you.
When you take the dividend option, whatever the fund, you are booking profits in your investments from time to time. When you do this, you hurt compounding. The compounding benefit in the growth option holds good for dividend yield funds and all other funds. Dividend plan is not ‘cheaper’ than a growth plan. There is no concept of cheap or expensive between funds or plans. This post will tell you why growth is preferable. If you want to be safe in your investments, it needs to be addressed through asset/category allocation more than dividend-growth.
Thanks,
Bhavana