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Dividend Yield Funds - valuable in volatile markets? - Outside View by PersonalFN

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Dividend Yield Funds - valuable in volatile markets?
Aug 5, 2011

While investing in the equity many of you investor being aware of the fact that equity as an asset class is the best to create wealth in the long-term, invest a dominant portion into "growth funds". When the equity markets display an upward rally, a thrill is experienced for sure (as growth funds deliver luring returns), but soon turns into a nervousness when the equity markets turn turbulent and volatile. Well, if you try to delve a little deeper and try to understand why such a feeling governs, one may realise that while growth investing is very promising to accentuate your wealth in the long-term, the portfolio characteristics reveal that such funds tend to plunge more during the downturn of the equity markets. Hence given the above, they are a good fit in your portfolio provided you are an "aggressive investor" (a high-risk taking investor), but a misfit if you have a moderate risk appetite and want to safeguard yourself during volatile times of the equity markets. Thus now the question arises - "which equity oriented funds would be the right fit, if one has a moderate risk appetite?"

Well, the answer to that is "dividend yield funds". This is because dividend yield funds invest in blue chip companies which:

√ Have a history of paying appealing dividends

√ Consistent performers (in terms of earnings) over the long-term

So, typically they (dividend yield funds) invest in companies which any value investor would keep on the radar at all times - and especially more when the valuations look attractive in the equity markets. Hence in a way such funds follow Mr Warren Buffett's (investment guru) style of investing, where the under-mentioned value investing principles guide the stock picking activity.

  • Companies should havesound management -
  • Yes, the fund managers to dividend yield funds very often opt for investing in companies which have sound management teams, as this acts as precedence for future earnings and thus return on investments. It is noteworthy that a company's top management enunciates the company's vision and ideologies, which should be evaluated well by you before investing your hard earned savings with the company.

  • Earning capacity of the companies-
  • Companies should be capable of generating good earnings consistently, as the fortune of its investors' is dependent on the same. Hence, it becomes imperative to pay attention to factors such as brand equity, Earnings per Share (EPS) growth rate, amongst others.

  • High Returns -
  • Companies should be consistent performing ones and those who are capable of generating appealing return of equity as well as return on capital.

  • Simple business -
  • Thebusiness of the company should be simple and you as investors should have thorough understanding of the business model. As a prudent investor you should never buy a business / stocks the business model is far complex and beyond your understanding.

  • Prudent approach towards debt financing -
  • Yes this is vital, because the company which is depending excessively on debt financing (particularly long-term debt) may eventually face a situation of a "debt overhang", whereby the interest coverage ratio of the company may get squeezed due to negative impact on the profitability due to rising interest cost.

  • Buy at the right price-
  • If all the aforementioned factors are satisfied, you should go ahead and buy companies / stocks. But while undertaking the stock picking activity, valuations need to be assessed as the objective of value picking is to buy companies / stocks at a reasonable price thus providing you a margin of safety.

  • Long-term investment approach -
  • Yes, this is the most vital point which you often ignore. When investing in companies / stocks you need to have a long-term investment approach, otherwise all the aforementioned investment principle would be defied, thus opening doors to momentum playing / gambling rather than "value investing".
But along with the aforementioned value investing principles which do throw light on the two famous quotes - "If a business does well, the stock eventually follows" and "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years" - both from Mr Warren Buffett; dividend yield funds also try to discover stocks which are available at attractive valuations due to their high dividend yields.

It is noteworthy that dividend yield refers to the cash flow received from every rupee invested in shares of a company, and the rationale of investing is based on the premise that generally such companies (which are mostly blue chips) do not alter their dividends to reflect trading conditions. Moreover, since dividend history is a true measure of ascertaining the true worth of the company (in midst of all business cycles and volatility of the equity markets) it in a way also helps in building a prudent portfolio to safeguard against extreme volatility, because such companies are always on the investment radar of many value investors.

At present in the Indian mutual fund industry there are 7 dividend yield funds. However Birla Sun Life Mutual fund was the first to pioneer the concept of dividend yield funds, through the launch of its "Birla Sun Life Dividend Yield Plus Fund" in February 2003. Today the Assets Under Management (AUM) of all the dividend yield funds have ballooned, but interestingly they still are a diminutive composition (around 2%) when seen in comparison to the total AUM of equity funds. This is because as we have mentioned earlier that most of you investors have shown penchant of investing in "growth funds", in an attempt to clock high returns.

Performance of Dividend Yield Funds
Scheme Name 6-Mth (%) 1-Yr (%) 2-Yr (%) 3-Yr (%) 5-Yr (%) Since Inception (%) Std. Dev (%) Sharpe Ratio Top-10 stocks (%) Portfolio Turnover Ratio (%) Expense Ratio (%)
Birla SL Dividend Yield Plus (G) -0.2 5.3 30.9 27.9 19.5 29.2 7.51 0.24 25.5 16.00 2.15
ING Dividend Yield (G) -0.7 4.7 33.3 24.7 19.5 15.9 8.75 0.19 40.4 76.74 2.50
BNP Paribas Dividend Yield Fund (G) 0.5 4.1 29.3 23.8 14.0 10.7 7.24 0.20 38.1 115.00 2.50
Tata Dividend Yield (G) -0.5 8.2 32.3 22.4 18.9 20.3 8.09 0.17 38.0 17.00 2.39
UTI Dividend Yield (G) -2.5 6.7 27.0 21.8 20.7 20.7 6.75 0.19 41.1 57.06 1.85
Escorts High Yield Eq (G) -0.4 9.0 25.2 14.7 - 8.7 7.05 0.11 39.3 8.70 2.50
Principal Dividend Yield (G) -4.0 3.1 24.1 13.3 10.4 13.1 8.24 0.09 42.4 74.00 2.46
Category average* -1.1 5.9 28.9 21.2 17.1 17.0 7.7 0.2 - - -
BSE-Sensex -5.7 2.6 16.7 11.0 11.0 - 9.29 0.06   - -
BSE-100 -5.3 0.9 16.8 11.0 11.8 - 9.67 0.06   - -
BSE-200 -5.6 0.1 17.6 11.4 11.9 - 9.78 0.07   - -
CNX 100 -5.3 1.8 18.5 12.2 12.2 - 9.38 0.08   - -
S&P CNX 500 -5.3 -0.3 17.2 11.3 11.3 - 9.67 0.07   - -
S&P CNX Nifty -5.7 2.7 17.4 10.9 11.6 - 9.13 0.06   - -
(NAV data is as on July 12, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period. Risk-free rate is assumed to be 6.37%)
*Note1: Category average has been calculated taking the "simple average" of all the funds.
(Source: ACE MF, PersonalFN Research)

However the performance of Dividend Yield Funds (which follow the value investing principles for stock picking) also reveals that most of them have clocked very enticing returns over a 2-Yr, 3-Yr, and 5-Yr time frame. Moreover barring Escort High Yield Equity Fund, all have rewarded their investors very well who have invested in these funds since inception.

Also a view of their risk characteristic (as revealed by the Standard Deviation) narrates that, they have exposed their investors to less risk. But the low risk has not refrained most funds from clocking appealing risk-adjusted returns (as revealed by the Sharpe Ratio). In fact the appealing returns have come by keeping the portfolio churning low, and not having a concentrated portfolio of top-10 stocks.

Performance across market cycles
Schemes / Index % Returns in bull phase % Returns in bear phase % Returns in bull phase
01-Aug-05 to 09-Jan-08 to 09-Mar-09 to
09-Jan-08 09-Mar-09 12-July-11
Escorts High Yield Eq (G)* 41.7 -46.3 36.5
Birla SL Dividend Yield Plus (G) 33.4 -44.5 50.6
BNP Paribas Dividend Yield Fund (G)* 23.1 -47.7 44.7
ING Dividend Yield (G)* 32.4 -51.2 57.2
Principal Dividend Yield (G) 30.0 -55.1 45.1
Tata Dividend Yield (G) 40.3 -52.6 55.1
UTI Dividend Yield (G) 46.2 -43.9 44.7
BSE SENSEX 50.7 -55.4 41.5
BSE-100 52.5 -58.1 43.1
BSE-200 51.6 -59.0 44.5
CNX 100 49.9 -55.6 41.8
S&P CNX 500 49.6 -58.3 41.8
S&P CNX Nifty 50.3 -53.5 38.6
* Returns in these funds for the 1st bull cycle is calculated from their respective inception date till 09-Jan-08
(Source: ACE MF, PersonalFN Research)

Stressing on the point of safeguarding your portfolio during volatile times (a defensive followed by dividend yield funds), the table above reveals that while they lagged their respective benchmark indices in the first bull phase - from August 1, 2005 to January 9, 2008, they precluded the portfolio from bleeding when the equity markets experienced a mayhem (due to sub-prime mortgage crisis in the U.S. and Lehman Brother bankruptcy) during the period from January 9, 2008 to March 9, 2009. Also when the equity markets recovered from the gloom from March 9, 2009 onwards, most of the dividend yield funds outperformed their benchmark indices returns, and accentuated wealth for their investors.

Portfolio Characteristics and strategy:

As mentioned earlier that while building a portfolio (of stocks), dividend yield funds focus on the value investing principles, they also emphasise on consistent performing stocks with a good track record of paying attractive dividends. This strategy of stock picking in a way helps such funds to discover good stocks at attractive valuations due to their high dividend yields.

Top 10 sectors
Top 10 Stocks
Name of the company % of holding*
Infosys Ltd. 5.2
ITC Ltd. 4.6
Tata Consultancy Services Ltd. 4.0
ICICI Bank Ltd. 3.6
State Bank Of India 3.3
NTPC Ltd. 3.0
Oil & Natural Gas Corpn. Ltd. 3.0
HDFC Ltd. 2.9
GAIL (India) Ltd. 2.5
Glaxosmithkline Pharmaceuticals Ltd. 2.4
Note: Sector holdings as on June 30, 2011
Top 10 stocks are also consolidated of value funds in the peer comparison table
(Source: ACE MF, PersonalFNResearch)

The latest portfolio of top-10 holdings reveals that the investments made by such funds are in robust companies of India Inc, but as regards following a market bias is concerned they are fairly multi-cap as they do not refrain from investing even in fundamentally promising mid and small cap companies, as they consider them as value picks for their portfolio.

As regards the sector bets are concerned, such funds as per the latest portfolio have displayed a dominant exposure to sectors such as Banks, Oil and gas, Software, Consumer Non-Durables and Engineering, as the companies within sectors offer promising future earnings, which thus elevate the chance of declaring attractive dividends as well.

The verdict:

It is noteworthy that while growth funds can help you accentuate your wealth, the importance of dividend yield funds should not be ruled out in your core investment portfolio, since during turbulence of the equity markets such funds (i.e. dividend yield funds) display a trait of restraining the downside risk (and thus preclude wealth erosion) due to the very nature of their portfolio which makes it well suited for investors with a moderate risk profile on account of the defensive strategy followed by such funds.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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