Dividend yield funds — Should you invest and how they are taxed?

In the last one-year amid volatility in equity markets, the Nifty Dividend Opportunities 50 — total return index (TRI) has outperformed the Nifty50. Also, dividend yield funds had 4,75,387 folios and the AUM (Assets Under Management) of Rs 4,416 crore in January 2020. The folio count has increased to 588,848 as of August 2022 and the AUM to Rs 10,123 crore, according to the data published by the Association of Mutual Funds in India (AMFI).

This growth journey can be related to the basic nature of dividend yield funds. Individuals park money in these funds as they are generally unaffected by stock market fluctuations and is rather packed with a high yield on investments.

So, before we get into more details, let’s first understand what it means:

Dividend yield funds are thematic mutual funds where a minimum of 65 percent of the AUM is invested in high dividend-yielding stocks. These funds primarily invest in equity shares of companies that declare dividends regularly.

Any firm will pay dividend to shareholders only when they are able to make a profit. This means that the underlying stocks of these funds are of companies that have strong financials.

Amit Nadekar, Senior Equity Fund Manager at LIC Mutual Fund Asset Management said that there are multiple reasons for an investor to choose a dividend yield fund.

Nadekar says dividends are an important source of wealth creation in equity markets and empirical evidence suggests that over a long period of 10 years plus dividends may typically account for 30-40 percent of equity returns while the balance 60-70 percent may be driven by capital appreciation.

Hence, investing in dividend yield funds makes immense sense, Nadekar said.

Two of the most followed investment styles are growth and value investing. Dividend yield funds fall in the value investing camp.

Generally, high dividend yield stocks are businesses in a mature phase with strong cash generation and slower growth rates. At times, quality growth franchises could also be available at attractive dividend yields due to short-term challenges of the business.

Given the higher yield and stable businesses, high dividends yield stocks are less volatile and fall lesser in a down market. Thus, dividend yield funds can build a portfolio of stocks with a stable business model and predictable cash flows, which in turn offer investors an opportunity to participate in equity markets with lesser volatility, Nadekar told CNBC-TV18.com.

According to Pankaj Shreshta — Head-Investment Advisory Division — Prabhudas Lilladher, dividend yield funds can be considered by investors who want stability in their portfolio and prefers low volatility in returns.

“This category is good for new equity investors and conservative equity investors,” Shreshta told CNBC-TV18.com.

However, it’s important to note that companies pay a higher dividend focus on paying out their profits to shareholders rather than reinvesting in the business for growth and expansion.

So, this category of funds will not be suitable for an investor who prefers to invest in growth stocks, Shreshta said.

The dividends offered by mutual funds are now taxed in the hands of investors as per the income tax slab they fall under. The rate of taxation of capital gains offered by these funds, however. depends on the holding period and the type of equity exposure.

If the equity exposure is more than 65 percent, then the rules of taxation of equity funds apply. If not, then the rules of taxation of debt funds apply, according to Clear.