Protect downside risk with dividend yield funds as they fall less

The equity market is expected to be more volatile in 2018 than in the previous year. In such an environment, investors should put a portion of their equity portfolio in value-oriented funds. Dividend yield funds are one such category, which have shown the ability to offer downside protection in all the declining markets of the past, such as those of 2008, 2011 and 2013.   

Surging crude price has emerged as a key risk that could worsen India's fiscal deficit, current account deficit, and inflation numbers. On the domestic front, several state elections followed by the general elections of 2019 could create political uncertainty. Risks could emerge globally from rate tightening by the US Fed, trade war between the US and China, and geopolitical tensions as witnessed vis-a-vis Syria and North Korea. After five-six years of single-digit growth, earnings growth is improving and the forecasts for 2018-19 are for double-digit growth. But these need to be taken with a pinch of salt until they actually materialise. The Nifty is up 0.32 per cent year-to-date, off 5.08 per cent from its peak value on January 29.

Dividend yield funds manage to protect downside risk because they invest in cash-rich companies. "These funds invest in companies with a good amount of free cash flow, which have the ability to pay regular dividends. In our fund, we also look for companies that can raise their dividend in the future, which in turn means that these companies are expected to see increase in earnings growth," says Swati Kulkarni, executive vice president and fund manager-equity, UTI Asset Management Company (AMC).

In declining markets, these funds tend to fall less than their benchmarks. "In such markets, your first objective is to protect your capital. Being conservative in nature dividend yield funds can help you do so," says Dhimant Shah, senior fund manager, Principal Mutual Fund.

Dividend yield funds have a value-oriented style. This style tends to perform better when markets are in correction mode. It also tends to outperform when valuations are low, and when valuations begin to expand. But once valuations have expanded, and growth gets re-rated, as happened after 2013, this style tends to underperform compared to growth and momentum-oriented funds. "Investors shouldn't have exposure only to growth-oriented funds. One style of investing doesn't outperform in all market conditions. That is why they need to have exposure to the value style of investing as well, which they can get with dividend yield funds," says Kulkarni.

When choosing a fund from this category, Shah suggests that you should look for those that have been able to consistently beat their benchmarks (see table). Also look at the dividend yield of the portfolio. A high dividend yield provides a cushion against volatility and indicates that the fund is attractively valued. It also points to the fact that the fund maintains style purity.

Some of the funds within this category are more large-cap oriented while others are mid-cap dominated. If you already have a high weightage of mid-cap funds in your portfolio, avoid buying a dividend yield fund as well that is mid-cap oriented. Owing to the higher valuations of midcap stocks compared to large-caps, they could also correct more sharply, and hence prove more volatile. "Smaller companies may also lack the ability to announce dividends regularly," says Nikhil Banerjee, co-founder, Mintwalk.    

Experts suggest that you may be safer going with one of the larger funds in the category. "If the fund size is large, it usually indicates that it has successfully navigated its way through several market cycles and given good returns in the past, which is what led to the inflows," says Banerjee.

A person could take a 10-20 per cent exposure (of his equity portfolio) to this category.

Banerjee suggests that conservative investors should hold these funds as a permanent part of their portfolios, while the aggressive ones should use them opportunistically -when the markets are volatile.

Outperformers among dividend yield funds            
    Rolling return performance     
Fund AUM (Rs billion) No. of periods Outperformance over benchmark (%)
UTI Dividend Yield Fund(G) 25.47 39 100      
BNP Paribas Dividend Yield Fund(G) 7.97 60 100      
ICICI Pru Dividend Yield Equity Fund(G) 2.07 11 100      
Principal Dividend Yield Fund(G) 1.28 39 100      
Tata Dividend Yield Fund(G) 2.96 60 93.33      

Rolling returns are three-year returns at monthly intervals for five years. The count should be 60, but it is less in some funds because the fund or the benchmark is not old enough

Source: Ace MF