Use Dividend Yield Funds to generate tax-free income

Use Dividend Yield Funds to generate tax-free income

Use dividend Yield Funds to generate tax-free income mutual fund best returns on investment 30 stades

Last week, Tata Mutual Fund launched Tata Dividend Yield Fund – an open-ended equity scheme predominantly investing in high dividend yielding stocks. The fund aims to provide capital appreciation and/or dividend income to investors by investing a minimum 65 percent of the net asset in a diversified portfolio of equity and equity-related instruments of dividend yielding companies.

The scheme also proposes to invest in real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) that own rent or income generating assets and pay regular dividends to their investors.

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The fund closes for subscription on May 17, 2021. So should you invest in this new scheme or similar schemes already available in the secondary market? The short answer is that it depends on your investment goals. 

Dividend paying companies tend to perform relatively better in volatile markets or when there is a lot of economic uncertainty. But they tend to underperform the broader market when investor optimism is high and the market gets red hot.

Given this, Dividend Yield Funds can complement your existing portfolio of diversified equity schemes but are not a replacement for traditional funds that are oriented towards growth stocks. 

As annual dividend income of less than Rs 10 lakh is tax-free, income seeking investors close to their retirement can invest in these funds by opting for the dividend option rather than the usual growth option.

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Dividend vs Growth

India, being an emerging market with low per capita income, is categorised as a growth market that offers new growth and investment opportunity to companies. This means that companies and their shareholders are better-off investing the surplus profits in new projects and ventures rather than return the cash to shareholders by way of equity dividends or share buybacks.

However, it’s also a fact that there has been a considerable slowdown in economic and corporate growth in India.  

For example, prior to the pandemic, the earnings per share (EPS) of BSE Sensex index, which tracks the combined profits of top 30 companies that are part of it, had grown at a compounded annual growth rate (CAGR) of around 5 per cent between FY15 and FY20. 

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The companies however compensated this by stepping-up the dividend pay-out — the ratio of net profit distributed to shareholders as equity dividend.  As a result, equity dividend by Sensex companies grew at a CAGR of around 10 percent during the period.

So there is an opportunity for investors to invest in high dividend paying companies. This is what the dividend yield funds are trying to capture. For example, 42 out of 50 companies in the Nifty 50 index paid dividends in their latest financial year. 

Also Read: 5 steps to rebalance your investment portfolio in 2021

The average dividend yield on a portfolio of Nifty 50 index is however just 1 percent, which means annual dividend income of Rs1000 for an investment of Rs1 lakh. This is too low.

This is where the fund managers at dividend yield funds step in. They invest in companies that offer dividend yield higher than the market average.  For example, Coal India has a dividend yield of 8.6 percent while ONGC offers a yield of 7 percent. Other companies with high yields are Power Grid Corp (6.3%), Bajaj Auto (6%) and ITC (5.9%).

Sectorally, IT services exporters such as Tata Consultancy Services, Infosys and Wipro are the biggest dividend payers in India and most dividend yielding funds have high exposure to these companies.

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Existing Dividend Yield Funds

Dividend Yield schemes are still a niche category in the Indian mutual fund industry and few fund houses offer a dedicated dividend yield scheme. As per 30 Stades research, currently there are five dividend yield schemes in the market.

The biggest of these is UTI Dividend Yield Fund with an asset under management of Rs2,618 crore as on March 31, 2021. The fund was launched in 2005 and its relatively smaller AUM compared to the universe of diversified equity schemes suggests that the concept is yet to gain traction in India. The fund has given 66 percent return in the last one-year and CAGR returns of 14.63 percent in the last five-years. 

The oldest scheme in the category is Aditya Birla Sun Life Dividend Scheme which was launched way back in February 2002. The fund reported an AUM of Rs 742 crore at the end of March this year. The fund is up 64.2 percent in the last 12-months.

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However, the top performing fund in the category is a relatively younger ICICI Prudential Dividend Yield Equity Fund which has delivered 36 percent returns in the last six-months and 77 percent in the last 12-months. 

Launched in 2014, the fund has an AUM of Rs 228 crore. Its returns are higher than the category average returns for diversified equity schemes. For example, in the last 12-months a typical diversified equity scheme has given 63.6 percent returns.

As such the fund was in the top quartile (or top 25% of the funds) among 211 diversified funds in terms of performance in the last 12-months according to data from ICRA Analytics Mutual Fund database. The fund also comes in the top quartile in terms of 5-year returns which hints at the consistency of its fund manager. The fund has given compounded annual returns (CAGR) of 12.44 percent in the last 5-year slightly less than category average of 13.6 percent.

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The Principal Dividend Yield Fund scores in the longer term with CAGR returns of nearly 17 percent in the last 5-years. The fund however lagged in short-term performance with returns of 61 percent in the last 12-months.

In all, three out of five Dividend Yield Schemes have given lower than category returns in the last one-year, which is not very different from what we see in diversified equity schemes in general.

The verdict

As the numbers show, hunt for dividend paying companies doesn’t guarantee superior returns but they can complement your investment in growth oriented diversified equity schemes. Invest in them with a dividend option that will generate tax-free income year after year.

(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

Also Read:  Top 10 Equity Mutual Funds with best returns in the last 6 months

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