Should you bet on dividend yield funds?

One value-oriented mutual fund category that has made a comeback over the past year or so is dividend yield funds. The category has given investors an average return of 68.9 per cent over the past year.

- Sudipta Mitu

How do these funds invest?

One primary filter that fund managers use is the dividend yield. This must be above a certain threshold, say, 1 or 1.5 per cent. The threshold could also be, say, the dividend yield of the Nifty 50.

Stocks that give high dividends consistently have usually crossed their younger, high-growth phase and have turned into steady cash cows. To ensure that they invest in companies that have the ability to grow (and do not stagnate), fund managers also look for stocks that they think can grow their earnings consistently and generate free cash flow.

The dividend yield of filter leads to the selection of high- quality companies that are in a steady growth phase. Companies that consistently pay dividend also tend to have low debt on their books.

Within the universe of stocks that pay high dividend yields, fund managers can find both growth stocks and value stocks. Building a portfolio that combines both these types of stocks can be very rewarding over the long term.

Dividend yield funds also tend to contain downside risk well. When the markets are falling, these funds tend to fall less than growth-oriented peers. The dividend yield of the portfolio acts as a buffer that prevents these funds from falling sharply.