Best Dividend Yield Funds - MF Explorer

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Best dividend paying mutual funds – dividend yield mutual funds

Dividends and mutual funds

‘Dividends’ has been an often misunderstood term as far as mutual funds go. Earlier mutual funds used to come with two options – growth and dividend. The dividend option, which basically involves distributing a portion of the fund’s NAV to the unit holders was often misunderstood to mean the distribution of profits generated by the fund, similar to a stock declaring dividends.

To clear up this oft-occurring confusion, SEBI re-christened dividends in mutual funds to IDCW, short for Income Distribution cum Capital Withdrawal. Our earlier article will answer the question - ‘What is IDCW in mutual funds?’ in great detail and look at the merits and demerits of the IDCW (formerly known as dividend) option.

Suffice to know that a mutual fund dividend is not comparable to a stock dividend. A mutual fund dividend is simply part of your profits in a mutual fund being paid back to you. A mutual fund is not obligated to pay you dividends. Even the best dividend paying mutual funds can skip paying dividends.

As a result, unlike a stock where it is possible to see dividends paid each year as a proportion to their earnings and their stock prices to arrive at those that are good on dividends, it is not possible to do so for mutual funds to narrow down the best dividend paying mutual funds.

Dividend yield mutual funds

For the best dividend paying mutual funds, investors often look to a separate category of mutual funds called ‘dividend yield mutual funds’. According to SEBI’s Categorisation and Rationalisation of Mutual Fund Schemes, dividend yield mutual funds ‘should predominantly invest in dividend yielding stocks’ and have a minimum of 65% of its investment in equity, making this category of funds fall under the umbrella of equity schemes. A dividend yield mutual fund however is not a dividend paying mutual fund. It is a fund where the stock-picking strategy considers a stock’s dividend yield as a key metric.

Where do dividend yield funds invest?

Dividend yield funds primarily invest in high dividend yield stocks. Looking for stocks with a high dividend yield is a strategy for picking quality stocks at attractive prices. Contrary to what the name of the fund category might indicate, these funds are not mandated to make high or regular dividend payouts to their investors. These funds therefore do not really qualify as the best dividend paying mutual funds. So what is dividend yield and how does dividend yield investing works as a strategy?

What is dividend yield and how do dividend yield mutual funds use it?

Dividend yield expresses annual dividend of a stock as a percentage of its current share price. This metric denotes the returns, from dividend alone, as against the price paid for the stock. Dividend yield is more a valuation metric; a high dividend yield indicates a lower price compared to the dividend income generated. It is thus often used as an indicator to pick stocks that will generate high dividend incomes.

For an in-depth look at this and other dividend related metrics useful in evaluating stocks on their dividend paying ability, do take a look at our earlier article on ‘best dividend paying stocks’. This is where dividend yield mutual funds will primarily seek to invest.

How dividend yield funds do this, is by investing in stocks that are trading at a dividend yield higher than an index. A dividend yield mutual fund does not put its entire portfolio in such high-yield stock, but a minimum as it will specify in its mandate. Each dividend yield mutual fund also picks different indices to benchmark their dividend yields.

As a valuation metric, funds use the dividend yield to identify stocks that are attractively priced or a quality stock that could be trading at attractive valuations. Stocks that fetch regular and attractive dividends are usually large and established companies that have reliable cash flows and cash balances to be able to send some of that the shareholder’s way.

When such stocks are trading at attractive valuations, their dividend yield gets higher (at the risk of oversimplifying) because the denominator – the stock price - gets smaller relative to the annual dividend which is the numerator. This therefore presents a buying opportunity, and is where dividend yield mutual funds aim to invest. Of course this metric will not be considered in isolation.

Dividend yield mutual funds will consider the dividend yield to shareholders in other forms such as share buybacks. Other important factors that dividend yield mutual funds consider include the dividend payout ratios and history to establish quality, fundamentals, valuations and business and sector outlook.

While the above factors guide where dividend yield funds invest, they are free to invest across sectors and across market capitalisations.

While the fund will earn from the dividends that these stocks pay out, it does not have any obligation or mandate to pay out dividends to its unitholders. Stock dividends received are reinvested and add to the fund’s NAV. Therefore, a dividend yield fund is not to be confused with the best dividend paying mutual funds.

What is usually the benchmark index?

The benchmark is an index used to measure the fund’s performance. You will find that most funds in this category are benchmarked against one of these:

To gauge performance, as an investor, one can use the Nifty 500 or BSE 500 as benchmarks for this category of funds.

Nature of returns and suitability

The best dividend paying mutual funds or dividend yield funds seek to invest in stocks that can add to returns via dividends apart from stock price appreciation. The nature of returns from this category would fall in the high risk – high return bucket as they can invest across market capitalisations.

What would also impact the risk and return profile of dividend yield funds is the sectors and market caps across which they have invested. Some sectors are riskier than others. Likewise, small cap and mid cap stocks can carry additional risks and volatility compared to large cap stocks. Since a dividend yield mutual fund is not restricted in market capitalisation, it can look for opportunities across the marketcap curve; funds with lower large-cap allocations will be riskier than those with higher allocations.

These funds, with equity being their main investment, need to be held for a minimum of 5 years to be able to provide gains to the investors. In the interim, like all equity investments, even the best dividend paying mutual funds can see volatility.

Dividend yield funds are best suited for long term financial goals such as building a retirement corpus, long term wealth creation or paying for a child’s higher education. They are not suited for the short or medium term at all and also not suited for beginner investors.

If it makes the cut, a dividend yield fund could find a place in the long term equity portfolio of investors with moderate to high risk appetites along with other diversified equity funds. Here however, it would be useful to consider overlaps between a fund’s portfolio and that of other equity funds such as large cap and flexi cap funds as the companies that are able to provide regular dividends could well find a place in the portfolio of such funds.

Taxation

Due to the minimum 65% of assets needing to be invested in equity, dividend yield mutual funds are a type of equity scheme and are taxed accordingly.

  • IDCW distributions are taxed at the hands of the investor at the applicable tax rate.
  • Short term capital gains (holding period less than 12 months) are taxed at 15%.
  • Long term capital gains (holding period of 12 months or more) above Rs. 1 lakh are taxed at 10%.

Evaluating dividend yield funds or best dividend paying funds

Evaluating dividend yield mutual funds or looking to get the best dividend paying mutual funds can be tricky. At the very least, one would need to evaluate:

  • Consistency of returns
  • Performance as against the category average, peers and benchmarked index
  • Degree of impact during market falls
  • Fund manager
  • Expense ratios
  • Dividend payout history, in order to check stability in payments and quantum of payments, to narrow down to the best dividend paying mutual fund

PrimeInvestor has the following solutions for investors:

  • At Prime Ratings, you can find a list of all the funds under the dividend yield category along with their 1-yr, 3-yr and 5-yr returns and our ratings of these funds. This can help you get started and scan the universe of dividend yield funds available in India.
  • The MF rolling returns vs. category tool can help you sharpen your analysis and compare a fund with others in its category and against the category’s average.
  • If you already hold some dividend yield funds or are considering one of them and want to know what we think, Prime Review is where you will find our call.
  • Prime Funds will take out all the guesswork and just tell you which funds we think you should consider investing in.
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