Dividend Yield Funds: Benefits, Risks & Things To Consider Before Investing

Mutual funds

Dividend yield mutual funds are equity funds that offer high dividend income by investing in companies that pay dividends regularly.

Companies that pay higher dividends have excellent cash flow, higher return on equity and an efficient management team committed towards its shareholders. Thus, investors can add stability and steady capital appreciation to their portfolios by investing in dividend yield funds.

Read on to know about Dividend Yield Mutual Fund, its benefits, and things to consider before investing. 

What is a Dividend Yield Fund?

Dividend yield mutual funds are open-ended equity funds that invest in stocks of companies with a proven track record of paying high dividends. As per SEBI’s guidelines, these schemes should invest at least 65% of their total assets in stocks. 

These stocks typically have a proven track record of delivering high profits as companies can pay dividends only when they have surplus cash. Dividend yield funds are ideal for investors looking to diversify their portfolios with top dividend yield stocks. 

Fund houses select high-dividend stocks by comparing dividend yields of indexes such as Nifty50 or Sensex. For example, if the current dividend of Nifty50 is 1.3%, the dividend yield fund will invest in companies that offer higher returns. 

Besides investing around 75% to 80% of the corpus in high dividend-paying companies, the fund manager invests the rest of the available funds in companies with high growth potential. About 20-25% of the corpus is usually invested in companies that pay little or no dividends.  

Who Can Invest in Dividend Yield Funds?

Dividend yield mutual funds are attractive for many investors looking for higher regular income. They are ideal for investors looking to invest in equities but not comfortable with high market volatility. This is because most of the underlying assets include stocks of financially sound companies. These equity funds are perfect for those wanting to earn regular and steady income over the medium to long term.

First-time investors may choose this type of fund as the underlying stocks are relatively stable and capable of sailing through volatile market scenarios. Retired investors can also get steady income in the form of dividend payouts. 

However, aggressive investors may not want to invest in such mutual funds as high dividend-yielding companies typically do not offer the highest returns.

Aggressive investors looking for high potential returns, may check out Navi Mutual Funds to start investing.

Also Read: Know About The Best Dividend Paying Mutual Funds

Benefits of Investing in Dividend Yield Funds

• Less Volatility: Companies that regularly pay dividends tend to experience lower volatility even when equity markets are underperforming. 
• Invests in Companies with Solid Financials: These mutual funds invest in companies with a proven track record of generating profits. These companies tend to trade at attractive valuations and have strong fundamentals, providing better capital appreciation opportunities.
• Offers Steady Cash Flow: Dividend yield funds provide a steady cash flow in the form of a regular income. Thus, these are suitable for investors looking for regular income with returns higher than debt instruments. 
• Risk Factor: These are less risky than other equity funds like mid-cap funds or small-cap funds. Investors can invest in these funds to hedge against market uncertainty and minimise the risk of volatility.
• Long-Term Returns:  Fund managers prefer bluechip stocks in the portfolio of dividend yield funds as they have an excellent financial track record. That is why such investments usually provide decent returns in the long run.

Risk vs Reward of Dividend Yield Funds

Like all equity investments, dividend yield mutual funds face risks depending on market conditions. Thus, the fund manager plays an important role in managing fund allocation to ensure stability in dynamic markets. 

Although these funds carry low risk as they invest in financially sound companies, they are associated with liquidity risk. Dividend yield stocks are less liquid based on their trading volumes in the stock markets. Moreover, there could be times when the fund underperforms compared to other funds in the market. 

It is also important to note that companies declare dividends only when they make high profits. Otherwise, they may pay below-average dividends or not declare dividends at all. 

The returns from dividend yield funds depend on the company’s performance in the overall market. During a bull run, these funds can deliver high returns, while in a bear phase, these returns could fall drastically. Investors who want to minimise risks should invest in a fund with a higher allocation to large-cap stocks.

Other Things to Consider before Investing in Dividend Yield Funds

• Fund’s Past Performance: Investors can analyse the fund’s past performance during both bull and bear phases of the market. This will tell them if a particular fund can be stable across various market cycles. They should also examine the mutual fund’s portfolio and asset allocation before investing.
• Financial Objective: The objective of a dividend yield fund is to provide regular dividends. Such dividends are not fixed or guaranteed and depend on the fund’s performance. Therefore, investors cannot fully depend on dividends as their sole income and should only use them to supplement their income.
• Expense Ratio: All fund houses charge a fee called expense ratio for managing the various expenses of a mutual fund scheme. Investors should check how much expense ratio is applicable as it will have an impact on their returns.
• Investment Horizon: These mutual funds work well to supplement your income through dividend payouts. Individuals with a medium to long term investment horizon can consider investing in these funds. 

Also Read: Taxation Of Dividend Income: Old vs New Provision, Deductions, And More

Final Word

Investing in dividend yield funds is a good way to generate some extra income while building your financial portfolio. Investors looking to build a diversified portfolio may want some exposure to these equity funds. However, they should check the fund’s historical performance, corpus size, and other aspects before investing.

FAQs On Dividend Yield Funds

1. Why do companies offer dividends to their shareholders? 

A lot of companies pay dividends from their profits to investors to make their stocks more attractive. Paying dividends make a company’s financials appear strong. Moreover, many companies offer buybacks for their shares to reward shareholders and improve the valuation. 

2.  When do various companies pay dividends to investors?

Dividend payout differs from one company to another but happens only when a company has surplus cash. Some companies pay dividends every quarter upon declaring their quarterly statements. Others pay it every six months or annually or have no fixed schedule.

3.  What is a dividend yield, and what is it used for?

The dividend yield is a ratio of a company’s annual dividend payout to its share price. You can refer to the company’s cash flow statement to know its actual dividend paid to calculate dividend yield. Investors often refer to this financial ratio to evaluate a company’s rate of returns as dividends.

4. How are dividends from mutual funds taxed?

Following the Union Budget 2020, dividends from mutual funds are taxable in the hands of investors receiving them. These are added to your taxable income and taxed as per the applicable income tax slab rates. Before this, mutual fund companies were required to pay DDT (dividend distribution tax) on dividends declared.

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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.

This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.