During a crash in the markets, everyone seeks refuge. A widely held assumption is that companies that pay dividends are more stable than others.
But will the assumption hold during a crash? Let us see how these funds operate.
What are dividend yield funds, and how do they function?
A dividend yield fund is an equity mutual fund where at least 65% of the fund is invested in dividend-yielding equities as per the rules laid down by SEBI for the categorisation of schemes.
The dividend yield is computed as the annual dividend divided by the market price of the share. Hence, a ₹10 dividend on a ₹200 share has a yield of 5%.
Managers select mature and well-managed firms that generate stable cash flows. These are typically in sectors like power, oil and gas, FMCG, IT, and banking, among others.
How do Sensex funds behave in a downturn?
Sensex funds are index funds that replicate the BSE Sensex, which consists of the top 30 large and established companies. They have a fixed allocation of stocks, regardless of whether these companies pay dividends.
Hence, a fall in the Sensex leads to a nearly equal percentage fall in these funds. There is no manager to mitigate risk.
During March 2020, the Sensex lost nearly 38% of its value from the peak level in January till the trough on 23 March. All equity categories were affected, including those that paid higher dividends.
Why does it fall less during a downturn?
There could be three reasons why the cushion works in a relatively slow and gentle correction:
- Low valuations: Value-type stocks have less of a bubble to burst compared to growth stocks.
- Income component: Dividends continue to flow irrespective of price drops and thereby reduce losses.
- Mature companies: Regular payers are mature businesses having consistent income and lower debt levels.
But in a rapid, broad-based selloff, all companies tend to drag.
Where do dividend yield funds fail?
This is where dividend yield funds fail and the investor gets trapped:
- Sector concentration: High-yield stocks are typically in metals, energy, and public sector firms. These stocks are cyclical in nature, and their dividends are reduced when profit levels decline.
- Slow recovery: When growth stocks drive the rebound, the dividend-oriented portfolio is lagging behind.
- No guarantee of payment: The dividends are company-dependent, which means that the dividend-paying fund may pay less than anticipated.
- Tax and NAV effects: Under the IDCW plan, the dividends reduce the NAV and are taxed as per your income bracket.
How can you utilise them?
Do not consider a dividend-paying fund as a foolproof insurance against crashes. Think of it as just one element in helping you balance your portfolio. Here is what you need to do before making an investment decision:
- Identify the top 10 stock and sector exposures of the fund based on its monthly factsheet. Ignore any fund where there is significant sector concentration.
- Find out how much the fund dropped compared to the Sensex during previous corrections, for example, in 2018, 2020, and 2022.
- Select the growth option if you want to earn via compound interest rather than the Income Distribution cum Capital Withdrawal (IDCW) option.
- Utilise the Systematic Investment Plan (SIP) route to invest and hold the fund for at least 5 years.
The sensible thing is to hold a low-cost Sensex fund as a core position and then hold a dividend-paying fund as a value addition.
Conclusion
In some situations, dividend yield funds may drop less than the general market as a result of low valuations and regular cash flow. However, they are not safe from market volatility. Sensex funds provide wide exposure to the market at lower costs, but they move in tandem with the index. On the other hand, dividend yield funds provide a value tilt but have sector exposure risk.
