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Explaining Dividend yield Funds
It is natural to assume that dividend yield funds are at least those that pay regular dividends.
On the contrary, despite its name, a dividend yield fund is not required to pay dividends. The name defines the strategy of the fund more than its ability to pay dividends.
What is Dividend yield Fund
To understand what dividend yield fund is, we need to understand what dividend yield is in the first place.
The dividend yield is the ratio of past paid dividends to the market price per share. Full and partial dividends are included in the payout. A stock may be one that pays good dividends annually, but the price of the stock may be high. The dividend yield comes into play to ensure that the asking price for this secure dividend is not too much.
A dividend yield fund places most of its portfolio in stocks with high dividend yields. There are two sections in this definition to be understood. The first is that the fund does not put its entire portfolio in good dividend payer stocks; a portion of the portfolio will go into any stock where the fund manager sees the potential. When stocks outside the dividend yield criterion do not pay out dividends, the amount of distributable surplus that the fund might have had will be decreased if it had invested the entire portfolio in high dividend payers.
The second point addresses 'high yields of dividends.' What's 'high' meaning varies with funds. UTI Dividend Yield and ICICI Prudential Dividend Yield connect it to the Nifty 50 which means that if the dividend yields of stock exceed the dividend yield of the Nifty 50 it is a high dividend yield stock. It is related to the Sensex by Tata Dividend Yield. It is linked to the Nifty Dividend Opportunities index by the Principal Dividend Yield.
Therefore, every fund has a different stock basket in which to invest. The Nifty 50 dividend yield is currently 1.26, the Nifty Dividend Opportunities index is 3.6, the Sensex 1.21, and the BSE 500 1.23. The dividend yield itself varies as and when dividend payments are made and stock prices drop. The number of stocks to invest in is significant due to the relatively lower dividend yield cut-off. Therefore, a fund may wind up keeping a 'high' dividend yield stock simply because it is higher than the average, but it may not pay high dividends.
Dividend or Strategy
So why would a fund look at dividend yields? This is because a dividend yield is a strategic tool for identifying value stocks. A stock with a high dividend yield is due to a low price.
If a company can reliably pay out healthy dividends over the years, calculated by the dividend payout as a proportion of earnings, this means it's a stable company. It means the company is cash-rich, it can balance income reinvestment for growth and dividend payment, it doesn't shorten its shareholders, it's built, and it's powerful.
The volatility of Dividend Yield Funds
For such a company the stock price may sometimes be small because it is not favored by the market or has not yet noticed it. The share price is low at such times while the dividend pay-out remains high. This means that it has a high dividend yield and also means that the stock has value (as the price is low). Consequently, a dividend yield strategy translates into a value-based strategy. These also include stronger downsides because they are value investments, being a testament to this in 2008 and 2011. The profit from dividends also balances the fall in stock prices to a degree. On average, the volatility of dividend yield funds is lower than that of the categories of both diverse and large-cap.
How Dividend Yield Fund works
Dividend yield funds follow the usual parameters for filtering out stocks. Blindly selecting high dividend yield stocks can result in investing in stocks of poor quality. Consistency in payments for dividends, their prospects for growth and fundamentals are also considered.
A dividend yield fund has more to do with value stock recognition than a high dividend payout. It doesn't have to pay a dividend. It will compress the distributable surplus of the fund when stock prices collapse and may make it unable to pay dividends.