Dividend yield funds have stocks in the portfolio that provide a high dividend yield. However, one should not expect them to do well under all circumstances
There is a special category of mutual funds that are available for investment for investors and these are the dividend yield funds. While the basic nature of the funds makes them equity oriented funds there is a different approach that is adopted when the portfolio of these funds is constructed. This ensures that the funds have to be considered separately and distinct from the other equity diversified funds. It has to be seen whether these funds add value for an investor in the portfolio and this can be done only when they are matched with the specific requirements of the investor.
Nature of fund
The basic nature of these funds is that they are equity oriented funds as their portfolio consists of equity holdings. However what is different is the manner in which the stocks are actually selected because there is a different basis on which this entire activity is undertaken. Usually there is an underlying investment theme that guides the decision of the fund manager when the portfolio is being constructed so for large cap equity diversified funds the stocks will comprise those that fall into the definition of large cap stocks as defined by the fund.
Dividend yield funds have stocks in the portfolio that provide a high dividend yield and the important thing to check here is the manner in which the dividend yield cut off has been decided. The dividend per share divided by the current market price of the share is the dividend yield that is earned on the share. This shows the percentage return in terms of the dividend received by the investor if the share is bought at the current market price. There is usually a figure that is decided by the fund which will be the cut off as far as the selection of the dividend yield stocks are concerned and hence this will become the guiding factor that will enable the choice of the stocks in the portfolio.
Why should you choose it?
The theory behind choosing dividend yield stocks for investment is that they can provide benefit in two areas. One is that these are companies that have a strong cash flow so they are able to provide a regular stream of dividends to their shareholders. Since this is a slightly higher figure in terms of the yield a part of the earnings arise through this specific route. The dividend flow is meant to provide an element of stability during tough times and hence these stocks are also suitable for a specific time or phase. There is also the benefit of capital appreciation that will occur due to the gains in the share prices that will be witnessed and these provide a second stream of income for the investor. The dividend yield way of investment thus has many followers who believe that this is a good way to go about the investment process and it can yield good results.
High Dividend yield stocks have performed quite well over the last few years especially in the light of the overall situation in the markets where the returns have not been very good. The dividend part adds a certain element of return to the overall investment which has remained quite steady and hence this has been a good thing and at the same time there has also been some capital appreciation which has boosted returns. On the whole these funds have provided the required amount of benefits for their investors. However one should not expect them to do well under all circumstances as usually in a bull market it will be witnessed that these funds actually lag the returns of the other equity oriented schemes as the dividend yield stocks might not show the same kind of strong capital appreciation. The circumstances thus often define the manner in which the funds perform.
Selection of stocks
The selection of the stocks for the portfolio is also not an easy thing because the criteria set for the investment will have to be met for a company to qualify for being included in the portfolio. There can also be circumstances where a good choice of the stocks might not be available. The moment there is a rise in the share prices the dividend yield will fall as is evident from the manner in which the dividend yield is calculated and hence the number of stocks that can be included in the portfolio will also fall. This results in a situation where the investor has to check two things - one is the manner in which the fund has defined the parameters for the purpose of the stock selection and the second is the manner in which the fund manager actually sets up the entire portfolio. Both these factors become important in the determination of the actual portfolio of the fund.
Another aspect that is often ignored is that this can result in a higher risk for the investor due to the manner in which the portfolio is actually constructed. It could be that the definition or the market conditions result in a situation where a lot of stocks from a particular sector fall into the definition of investment. If a lot of these are added to the portfolio then the overall risk will increase as they will perform in a specific manner when there are common conditions that will drive the situation. Some examples of this will be banking stocks where the dividend yield goes higher as the prices fall due to conditions that are specific to the sector.
There can also be a situation where the position is not evident but it still results in a higher risk for the investor. For example there could be a lot of public sector stocks or oil stocks that might qualify as these might fulfill the conditions in terms of the definition of investment. At the same time there are a lot of other factors that are actually impacting the investment that is depressing the stock prices so that this might not result in much or any capital appreciation which will hit the final position.
Consider the past
There is one factor over which the investor will not have any control and hence there is a need to take this into consideration. When it comes to the dividend yield the way in which this is estimated is by looking at the past dividend as the next dividend will come only sometime in the future. When this is the case there is a chance that if the conditions or performance of the company actually worsens then this will impact the dividend that will be paid in the coming year.
This can result in a strange situation as the stock might have a high dividend yield as its price falls but this might not be good news for a long time as the dividend would also fall at the next payment period. This will actually result in a lower dividend yield coming for the investor but it is a situation that no one can do much about. There is also a way in which this position can be tackled and this is by looking at a stream of dividends in the past few years to see the consistency of the dividends that are being paid. In many cases even an average of the dividend for the past many years could be considered.