Equity and equity-related instruments have one of the highest returns potentials. But apart from the capital gains, equity as an asset class also delivers returns in the form of dividends. A lot of companies in India share a part of their earnings with their investors by paying dividends. While paying dividends is not mandatory, many companies do it as it makes their stocks more attractive for the investors.
If direct equity investment is too risky for you, you can still take advantage of dividends by investing in dividend yield funds. Let us have a look at what is dividend yield fund and how they work.
When you invest in an equity mutual fund, like a sectoral IT fund, it will invest your money across stocks of multiple IT companies. A dividend yield fund is also a type of equity fund where investment is made in the stocks of companies that regularly declare dividends.
A company is only able to declare dividends if it is making healthy profits. So, the companies that are known to generally declare high dividends are ones with strong financials and excellent cash flow.
Most fund houses select 'high dividend' companies by comparing the dividends yield of the company with the dividends yield of an index like Sensex or Nifty 50.
For instance, the current dividend yield of Nifty 50 is close to 1.25. So, a dividend yield fund that is based on Nifty 50 will prefer investing in companies with a dividend yield of above 1.25.
No, most funds generally invest about 75%-80% of their portfolio in such high dividend companies, and the rest is invested in stocks that the fund manager believes have high returns potential.
So, even companies that have low dividends yield or even ones that do not pay any dividend can be selected by the fund managers to invest the remaining 20%-25%.
As these are equity funds, they are not recommended for individuals looking for stable returns with low volatility. While the funds invest the money in financially sound companies with an excellent track record, the returns may not be stable and can be volatile between bull and bear cycles.
Even aggressive equity investors should avoid investing in these funds as stable, high dividend yield companies are generally not known to deliver very high returns. Pure equity funds like mid-cap and small-cap can be a better choice for aggressive investors.
This type of fund is recommended for individuals who want to invest in equity but are not very comfortable with the high volatility of the market. But with that said, limited exposure to dividend yield mutual funds is recommended for every investor aiming to build a diversified portfolio.
If you are planning to invest in dividend yield funds, make sure that you consider funds with a decent corpus size, low historical volatility, and low expense ratio.
Avoid making decisions based on the recent or current performance of the fund as these funds could deliver high returns during the bull phase of the market. The returns can fall drastically during the bear phase. So, focus more on the historical data and analyse the fund's performance during bull as well as bear phases to make a better decision.