Dividend Yield Funds
Dividends are a crucial aspect of investing in equity or equity-related instruments. Many organizations share a portion of their profits with their shareholders by declaring dividends. Some companies may pay high dividends while some companies might not pay any dividends at all. In this article, we will learn all about dividend yield funds, how they work, and their benefits, so that you can see whether these funds will be an excellent addition to your investment portfolio or not.
Before we learn what dividend yield funds are, we should know about dividends.
What Are Dividends?
After paying its creditors, a company can use a portion or whole of the residual profits to reward its shareholders as dividends. Dividends can be issued in various forms, like cash payment, stocks, or any other form. A company's dividend is decided by its board of directors and it requires the approval of its shareholders. On the other hand, when companies face cash shortage or when it needs cash for reinvestments, they can choose not to pay dividends.
What Are Dividend Yield Funds?
Dividend yield funds are mutual funds that invest majorly in companies that have an excellent track record of offering higher and relatively regular dividends to the investors. These funds are equity funds that invest in equity and equity-related instruments of companies, which are known to declare high dividends. The main aim of dividend yield funds is not the capital appreciation but to identify and invest in stocks that provide regular dividends to the investors.
How Do Dividend Yield Funds Work?
As mentioned above, dividend yield funds are equity, which majorly invests in equity instruments of companies, which can give high dividends. The SEBI guidelines state that these funds have to invest at least 65% of the fund in dividend-yielding instruments to be qualified as dividend-yielding funds.
We've been mentioning the words, 'Dividend Yield' a lot. So, what does it actually mean?
Dividend Yield showcases the company's paid dividends in the span of a year. It is the yield shown as a percentage and not as the actual amount. It helps in viewing the return per amount invested via dividends by the shareholders.
Sometimes, investors mistake Dividend Yield Funds for funds that pay high dividends. However, these funds invest a major portion of the corpus into dividend-yielding stocks for above-average returns, i.e. investing in stocks that pay an above-average dividend regularly. Dividend Yield funds are less volatile because their average returns are lower and are consistent, unlike large-cap and multi-cap stocks that are volatile and have faster growth.
What Are The Types Of Dividend Yielding Mutual Funds?
Dividend Yielding mutual funds can be classified into two categories based on asset allocation, returns generated, and taxation. Below are the classifications.
1. Dividend Yielding Mutual Funds (Equity)
If a dividend mutual fund allocated a larger portion of its assets (more than 65%) in equity classes, it will be classified as Dividend Yielding Mutual Fund (Equity). Equity Dividend Yielding mutual funds are considered to be highly volatile in nature.
2. Dividend Yielding Mutual Funds (Debt)
If a dividend mutual fund has allocated more than 65% of its assets to debts in the investment portfolio, it will be classified as Dividend Yielding Mutual Fund (Debt). These mutual funds are less volatile in nature when compared to equity dividend-yielding mutual funds. The dividend in these mutual funds is paid from the income of debt funds that comes from the trading of bonds in the market or earning interest on bond/debt holdings.
Dividend Reinvestment Plan
A dividend reinvestment plan is a variant of mutual funds wherein the dividend declared by the mutual funds is reinvested in the mutual fund. In this plan, the dividend paid out is reinvested at the post-dividend NAV (Net Asset Value) of the fund.
Here's how they work - Let's say, you invested ₹10,000 in a mutual fund where the NAV was ₹5 per unit. So, you will be allotted 2,000 units. If the mutual fund scheme announces a dividend of ₹1 per unit for the financial, and the NAV at the end of the year is ₹10, your total investment value will increase to ₹20,000 (15 x 2000 units). In a dividend and dividend reinvestment plan NAV reduces by ₹1 to ₹9 per unit. Dividend = ₹1 x 2,000 = ₹2000.
In the dividend reinvestment plan, ₹2,000 has to be invested back into the plan, we need to find out how many units will come for that amount because what gets invested back is a fresh batch of units. When investors invest a certain amount in mutual funds, the number of units for that amount gets credited to their accounts. Since ₹2,000 will be put back into the fund, we need to find out the worth in terms of units.
The new NAV is ₹9 and the number of units in dividend reinvestment will be 222.22 units (4,500/9). So, your new number of units will be 2,222.22 (2,000 + 222.22). So, the total value of your investment will be the number of units x post-dividend NAV - 2222.22 x 9 = ₹19,999.98.
Dividend Sweep Option
A dividend Sweep Option (DSO) is a facility wherein investors of eligible schemes of an AMC (Asset Management Company) can choose to automatically invest the dividend declared by the eligible scheme into other eligible schemes.
For example, you own 200 units in the Axis Bluechip Fund (Dividend Plan) and the fund declares a dividend of ₹7 per unit. The total value of your fund is ₹1400 (200 x 7). In a dividend sweep plan, ₹1400 will be used to buy units of another mutual fund scheme of Axis AMC (for instance, the AMC is chosen by the investor).
Who Should Opt For Dividend Yield Funds?
Dividend Yield funds are suitable for investors with moderate to high-risk appetites, who want to invest in the equity market but also want to limit their risk. These mutual funds usually offer good returns even in the short term. Hence, even risk-averse investors can consider adding these funds to their portfolio, while investors with short-term investment horizons, and those looking for a regular source of alternate income can invest in these funds too.
As mentioned above, these mutual funds aim at providing more or less a stable source of income to investors. The number of dividends and the frequency cannot be guaranteed as it depends on the performance of the fund against market volatility. Meanwhile, this fund invests in primarily financially sound companies that have a good track record of offering dividends, so it is a good investment option that can be considered by investors who are looking for a passive income.
What Are The Benefits Of Dividend Yield Funds?
Here are some of the benefits of investing in dividend-yield mutual funds.
Diversification
Diversification is the biggest benefit of any mutual fund. Investors get the benefit of earning potentially higher returns via an array of investments made across several companies, sectors, industries, asset classes, etc., This helps investors earn potentially higher returns via their investments in dividend yield funds.
Lesser Risks
The risks of these funds are comparatively lower than those investing in individual high-dividend yield stocks or instruments. The benefit of diversification helps in reducing the risks of investing. Most of the dividend-yielding instruments are cash-rich organizations having a sound business model and proven track records, so the risk of investments in these instruments is further lowered.
Steady Income
Dividends are usually considered a source of passive income, which can be used to purchase more stocks of mutual funds. They are less aggressive and are a source of steady income because of this aspect.
Protect Against Inflation
These mutual funds have a settling stage after which they don't fall. These dividend yields act as barriers to a further plunge in funds beyond a point.
Dividend Value
These funds have price-to-earnings ratios or price-to-book value ratios that show the inexpensive segment of the market.
High Yield
These funds are best suited for investors with short-term investment horizons. However, they have the potential to offer a higher yield in the long term. So, these funds are ideal for investors who have either short-term or long-term investment horizons.
Best Option For New Investors
Since dividend yield funds have lower risks and more or less regular returns potential, these funds are suitable for newbie investors. So, new investors, who have a lower risk appetite and limited experience, can consider investing in these funds.
What Are The Factors You Should Consider Before Investing In Dividend Yield Funds?
Dividend Yield funds are said to be a good addition to most kinds of investors. However, there are a few things that you should consider before you invest in these funds.
Investment Objective
Dividend yield funds are suitable for investors who are looking to create regular income. So, if your goal is to create wealth, these funds might not be suitable for you.
Investment Risk
If you are a conservative investor who is considering the dividend yield fund to add stability to your portfolio, you must look for funds that have a higher allocation to large-cap stocks because your objective is to invest in a scheme that has low risk. It is a good idea to consider your risks before choosing any mutual fund.
Fund Reputation
It is important to analyze the fund's reputation to understand the past record of the frequency of the payouts made by the fund. This will help investors make an informed investment decision and avoid funds that have a poor track record in this category.
Fund Performance
It is crucial to evaluate the fund's performance before choosing a fund. Even though the returns of the fund are not guaranteed, you can use fund performance as one of the factors to make a profitable investment decision.
Tenure Of The Fund
A dividend yield fund that has gone through multiple market cycles is in a better position to provide stable returns as compared to a relatively new fund. So, choose a fund that has given good performance across different market cycles.
Think Twice Before Choosing Small Corpus Funds
When choosing to invest in a dividend yield fund, many experts recommend that investors should stay away from schemes with a small size corpus. The reason behind this is that the right investment strategy can make the fund look better as compared to others and even a couple of mistakes can plunge it to the bottom of the performance table.
Expense Ratio
Investors must understand the costs involved in investing in dividend yield funds. The expense ratio is the amount charged by fund houses for managing the fund. If the expense ratio is high, it will reduce your returns.
What Is The Taxation On Dividend Yield Funds?
Dividend Yield funds attract Dividend Distribution Tax (DDT).
The dividends paid by equity mutual funds are subject to a DDT of 10%. However, this tax is deducted at the time of paying a dividend. Hence, the dividend is tax-free in the hands of the investor. DDT on non-equity funds such as debt mutual funds, and money market funds is 25%. Even though dividends on non-equity funds are tax-free at the hands of investors, a very high rate of taxation makes them tax-efficient.
In The End…
Dividend Yield funds are an ideal investment option for those who are looking to invest in equity but also want to limit their risk. They are perfect for investors who are looking to earn passive income.
We hope this article helped you understand all about Dividend Yield funds and how they can help you achieve your goals. It is important to learn how Dividend Yield funds will benefit you and what factors you should consider before investing in them.
If you wish to learn more about other types of mutual funds, including ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.
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