Dividend yield funds are a type of mutual fund that invests in companies that have a history of paying high dividends. These funds aim to generate income for investors by investing in high-dividend-yielding stocks. As per SEBI, a dividend yield fund must invest minimum 65% of its assets in equity and its associated instruments. In this article, we will discuss the basics of dividend yield funds, their advantages and limitations, and factors to consider before investing in them.
What are dividend yield funds?
Dividend yield mutual funds are a category of equity mutual funds that invest specifically in stocks of companies that pay out high dividends. These funds focus on stocks that provide higher dividend yields compared to the average market level. The portfolio of dividend yield mutual funds includes established blue-chip companies, utilities, and realty firms.
Here are key points about dividend yield funds:
- Purpose: They aim to generate income for investors by investing in high-dividend-yielding stocks.
- Risk profile: These funds are considered low-risk compared to other equity mutual funds.
- Investor suitability: Ideal for investors seeking regular income from their investments.
Remember, dividend yield funds strike a balance between income generation and risk management, making them suitable for those who prioritise stability and passive income.
How does a dividend yield mutual fund work?
A dividend yield mutual fund typically allocates its investments into equities of companies known for their higher dividend payouts. These funds specifically target firms with a history of increasing dividends or offering substantial dividend yields.
Conversely, a mutual fund featuring a dividend option may not suit every investor, primarily because its Net Asset Value (NAV) does not experience rapid growth. This scenario arises when dividends are promptly distributed once a specific threshold is met.
Therefore, dividend yield mutual funds are most suitable for investors with a low-risk tolerance who seek regular monthly payouts as a dependable income source.
Features of dividend yield mutual funds
The Indian mutual fund market includes numerous mutual funds that offer good returns to investors. Dividend-yield mutual funds invest in equity schemes when their main goal is to amplify investors' returns. Such schemes help fund managers ensure that they can use dividend payouts in equities to increase overall returns.
Here are some of the main features of dividend-yield mutual funds:
- Income generation: Dividend-yield mutual funds primarily invest in stocks and securities that are known or have the potential to offer high dividends regularly. The high and regular dividend payout allows investors to benefit from steady income.
- Investment strategy: Dividend-yield mutual funds invest in companies with a history of paying high dividends. These are often mature, stable companies with consistent earnings. The included companies have the option to either distribute the profits through dividends or reinvest the profit for a better business approach.
- Earnings potential: Most dividend-yield mutual fund investments are in stocks that offer consistent dividends. Thus, these funds allow investors to earn from both dividend income and any capital gains from changes in the value of the included investments.
- Diversification: One of the best features of dividend-yield mutual funds is their diversification potential. These funds often invest across various sectors, providing diversification and reducing the risk associated with investing in a single sector. Some funds may include international dividend-paying stocks, offering global diversification.
- Asset allocation: According to SEBI (Securities and Exchange Board of India) guidelines, dividend-yield mutual funds must invest at least 65% of their assets in dividend-paying stocks. This requirement ensures that the fund maintains its focus on generating income through dividends and aligns with its steady income objective.
Types of dividend-yielding mutual funds
Dividend-yield mutual funds are designed to provide investors with regular income through dividends. These funds invest primarily in dividend-paying stocks, but there are several types of dividend-yielding mutual funds based on their investment focus and strategy:
Dividend-yielding mutual funds (Equity)
Dividend-yielding mutual funds in the equity class invest a majority of the assets (over 65%) in dividend-paying stocks. Their main goal is to provide income through dividends while also aiming for potential capital appreciation. Most of these equity funds invest in stable companies, generally in the large-cap segment, to ensure lower risk and constant dividend payouts. These types of funds are highly volatile and carry higher risk as they invest in equities. However, the return potential is higher in these types of funds through dividend payouts and capital appreciation.
Dividend-yielding mutual funds (Debt)
Dividend-yield mutual funds that invest a major portion of the assets (over 65%) in debt securities are known as debt dividend-yield mutual funds. These funds invest in fixed-income securities such as bonds, debentures, and other debt instruments that pay regular interest. Their main goal is to provide income through interest payments rather than dividends. The funds choose debt instruments that are high quality and come with high credit ratings. Debt dividend funds generally offer lower risk compared to equity funds since they are less volatile. However, they also provide lower potential returns.
Advantages of dividend yield mutual funds
- Diversification
Dividend yield funds invest in a diversified portfolio of stocks, which helps to reduce the risk of investing in a single stock. - Lower risk
Dividend yield funds are less risky than other forms of equity mutual funds, which makes them low-risk funds and most suitable for investors who have a low-risk appetite. - High yield in the long term
Dividend yield funds aim to generate income for investors by investing in high-dividend-yielding stocks. These funds offer a high yield in the long term. - Ideal for new investors
Dividend yield funds are ideal for new investors who are looking for a regular source of income.
Taxation of dividend yield funds
Following the amendments introduced in the Union Budget 2020, dividends distributed by mutual funds are now subject to taxation based on the investor's income tax slab. Additionally, the taxation rate on capital gains generated by these funds relies on the duration of holding and the extent of equity exposure within the fund.
When the equity exposure surpasses 65%, the taxation regulations applicable to equity funds come into effect. Conversely, if the equity exposure falls below this threshold, the taxation rules of debt funds are applied. Hence, it's essential to be aware of the fund's equity exposure before investing, as this enables more effective tax planning strategies.
Who should invest in a dividend yield mutual fund?
Dividend yield mutual funds are ideal for investors who are looking for a regular source of income. These mutual fund schemes are also suitable for investors who want to invest in equity but are looking for lower volatility.
Taxation rules of dividend-yield mutual funds
The taxation rules for dividend-yield mutual funds were changed in the Union Budget 2024, announced in July. According to the new taxation rules, the long-term capital gains tax and short-term capital gains tax rates have been changed, and the indexation benefit has been removed. The indexation benefit helped adjust the price of the mutual fund units to account for inflation.
Here are the new taxation rules for dividend-yield mutual funds:
- Long-term capital gains tax: The LTCG tax is 12.5% as per section 112A of the Income Tax Act. The new tax rate is for units sold after 12 months and is without indexation benefits for gains exceeding Rs. 1.25 lakh.
- Short-term capital gains tax: The STCG tax is 20% for equity-oriented mutual funds, including dividend-yield mutual funds for units sold before 12 months.
Limitations of dividend yield mutual funds
While they carry several advantages, dividend yield funds are not immune to inherent risks. Here are some of their limitations:
- Limited Capital Appreciation
Dividend yield mutual funds primarily focus on income generation, potentially limiting their capital appreciation compared to growth-oriented funds. Investors seeking substantial capital gains may find these funds less suitable for their objectives.
- Not Suitable for Short-Term Goals
These funds are typically more suitable for long-term investors seeking regular income. For investors with short-term financial goals, the fluctuation in dividend payouts may not align with their income needs.
List of Dividend Yield Mutual Funds
- SBI Dividend Yield Fund
- HDFC Dividend Yield Fund
- ICICI Prudential Dividend Yield Equity Fund
- Tata Dividend Yield Fund
- Aditya Birla Sun Life Dividend Yield Fund
- UTI Dividend Yield Fund
- Templeton India Equity Income Fund
- Sundaram Dividend Yield Fund
- LIC MF Dividend Yield Fund
Factors to consider before investing in dividend yield funds
Before investing in dividend yield funds, investors should consider these factors:
- Risk tolerance
Investors should consider their risk tolerance before investing in dividend yield funds. It is suggested to properly understand the market and economic risks and then make your investment choice.
- Tenure of the fund
Investors should look into the duration of the fund’s investment tenure. A dividend yield fund that has seen the stock market’s bull and bear phases will provide a higher return than newer companies.
Conclusion
Dividend yield funds are a type of mutual fund that invests in companies that have a history of paying high dividends. These funds aim to generate income for investors by investing in high-dividend-yielding stocks. Dividend yield funds offer several advantages; however, investors should also consider the limitations of dividend yield funds, before putting in their money.
