Why dividend yield funds are more rewarding in volatile times like these

The wild swing in the market since the beginning of 2020 has thrown up an interesting winner — dividend yield funds. So far this year, these funds have managed to contain losses better than the bellwethers — the Nifty 50 TRI (Total Return Index including dividends) and Sensex TRI — as well as the broader markets represented by the Nifty 500 TRI and BSE 500 TRI.

Over the past year, the performance of this category of funds has beaten large-cap funds (known to contain losses better in falling and volatile markets) and even multi-cap funds (which invest in stocks across the breadth of market capitalisation).

There are currently five funds, from UTI, Aditya Birla Sun Life, Principal, ICICI Pru and IDBI, that invest in domestic stocks with high dividend yield.

“We have seen a mini-cycle playing out this calendar year, with the markets falling 35-40 per cent till late March and then gaining 40 per cent since then. Whenever we see markets going through such a test, we see classical investing styles, which include dividend yield, working out quite well,” says Mrinal Singh , Deputy CIO, Equities, ICICI Pru AMC.

The pattern

Dividend yield funds, for instance, did well to contain losses in the 2011 fall as well as during bearish phases in 2018. The category though may tend to underperform in bull markets. The strategy, thus, suits investors who prefer lower volatility. “Globally, pension funds invest in dividend yield strategies because it is a good income-generation route. This makes sense now when there is paucity of fixed income returns globally,” adds Singh.

However, dividend yield-based investing has a downside. One-off events such as special dividends or a sharp fall in the market price may push up the dividend yield for a stock. Investors who bet on individual stocks based on high dividend yield in the latest year alone may thus end up disappointed. Dividend yield funds, on the other hand, follow a more robust strategy.

Says Swati Kulkarni, Executive Vice-President and Fund Manager – Equity, UTI AMC, “We not only look at the current dividend yield but also the ability of the company to show growth. Even if the dividend payout ratio remains constant, earnings growth will ensure higher dividends every year. Secondly, we look at the free cash-flow yield. When a company generates cash flows, it will have the confidence to distribute it to shareholders. In our dividend yield fund, we have about 30 per cent of the portfolio in companies where free cash-flow yield is higher than the current dividend yield.”

What’s in store?

FY20 was a good year for these funds, with the dividend outgo for Nifty 500 companies moving up about 4 per cent year-on year to ₹1.9-lakh crore, even as profits dropped 24 per cent. The payout ratio stood at 48 per cent — a big jump from the 35-38 per cent levels seen in the last few years. The tax on dividends in the hands of shareholders from April 1, 2020, seems to have driven this trend, as many companies advanced their dividend declarations.

Covid-19 could dim the picture for this year. Already, banks and insurance companies have been asked not to declare dividends for FY20 to conserve capital; they may continue to retain earnings this fiscal, too.

ICICI Pru AMC’s Singh agrees that companies in the financials space may not be able to pay dividends this year. However, he finds pockets of opportunities in PSUs which have a stable dividend policy. He expects companies in the consumption space (FMCG) as well as IT players to continue paying dividends.

“If earnings decline, absolute dividends might reduce even assuming the payout ratio remains constant. But if prices also move down when earnings are down, dividend yield itself may not alter much. That said, dividend yield is a small portion of the overall returns. Funds choose stocks using this as a first filter. Then the portfolio is constructed based on the potential for capital appreciation as well as the sustenance of dividends,” reasons UTI AMC’s Kulkarni.

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