Your Questions Answered: We are a retired couple. Should we invest our gratuity in dividend-yield mutual funds?

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Dividend yield funds are a type of equity mutual funds that invest in stocks that pay regular dividends to their shareholders. Dividends are a portion of the profits that a company distributes to its investors, and the dividend yield is the ratio of the annual dividend per share to the current share price, expressed as a percentage.

Dividend-yield funds aim to generate income for their investors by investing in high-dividend-yielding stocks. According to SEBI, a dividend yield fund is required to invest at least 65% of its assets in equity and equity-related instruments.

Will dividend yield funds pay dividends regularly? 

It is very important to understand that most mutual funds including dividend yield funds have two variants or two options: growth option and income distribution cum withdrawal option (IDCW option). In the case of the growth option, the investors do not receive any payout in the form of dividends. Whereas in the case of the IDCW option investors may receive dividends at the discretion of the mutual fund management. We have elaborated on the difference between the two options below.

IDCW option

Payouts: This option may provide payouts to investors at the discretion of the fund management. The amount of payout depends on the fund’s performance and the fund manager’s decision.

NAV: The (NAV) net asset value of the IDCW option can fluctuate due to dividend payouts, potentially being lower than the growth option over time.

Taxation: Dividends are taxed at the investor’s income tax slab rate, while capital gains withdrawn are taxed at the flat rate of 10% if the fund’s units were held for more than one year and at the rate of 20% if the fund’s units were held for less than one year.

Growth option

No payouts: This option doesn’t offer any regular payouts. All profits and capital gains are reinvested back into the fund, leading to compounding and potential long-term wealth accumulation.

Profit reinvestment: All profits earned by the fund are used to buy more units of the fund, contributing to growth in the NAV.

NAV: The NAV of the growth option generally grows steadily over time due to compounded returns.

Taxation: As mentioned above capital gains withdrawn are taxed at the flat rate of 10% if the fund’s units were held for more than one year and at the rate of 20% if the fund’s units were held for less than one year. This provides tax deferral benefits compared to IDCW.

Benefits of dividend yield funds

Some of the benefits of investing in dividend yield funds are:

Regular income: Dividend yield funds can provide a steady source of income for investors who are looking for passive income or to supplement their regular income. As mentioned above investors have to choose the IDCW option. It is important to note that dividend distribution is dependent on the discretion of the fund’s management and is not guaranteed. 

Lower risk: Dividend yield funds generally have lower risk than many other types of equity mutual funds, as they invest in companies that have a stable and consistent track record of paying dividends. These companies are usually well-established, mature, and have strong cash flows. They are less likely to be affected by market volatility or economic downturns.

Risks of dividend yield funds

Some of the risks of investing in dividend yield funds are:

Dividend uncertainty (company): Dividends are not guaranteed and depend on the company’s profitability, cash flow, and dividend policy. A company may reduce or skip its dividend payment if it faces financial difficulties or needs to reinvest its earnings for growth. This can affect the income and returns of dividend yield funds.

Dividend uncertainty (IDCW option): Dividends are not guaranteed even if an investor chooses the IDCW option and depend on the mutual fund’s surplus, cash flow, and dividend policy. A mutual fund may reduce or skip its dividend payment if it faces financial difficulties. 

Opportunity cost: Dividend yield funds may miss out on higher returns from other types of equity mutual funds that invest in growth-oriented or value-oriented stocks. These stocks may not pay high dividends but may offer higher capital appreciation over the long term.

Performance of dividend yield funds

The performance of dividend yield funds depends on various factors, such as the dividend payout ratio, dividend growth rate, dividend sustainability, and valuation of the underlying stocks. The performance also varies across different time periods, market cycles, and fund managers.

As of 30th January 2024, the top 5 dividend yield funds have given a return north of 18% in the past 5 years (CAGR) (The above returns are based on the direct plans and growth options of the dividend yield funds). 

In conclusion, dividend yield funds are a suitable option for investors who are looking for a regular income, lower risk, tax efficiency, and capital appreciation from their equity investments. However, investors should also be aware of the dividend uncertainty, limited diversification, and opportunity cost of these funds. Investors should also consider their risk appetite, investment horizon, and financial goals before investing in these funds.

Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.

Kuvera is a free direct mutual fund investing platform.

 

 

 

 

 

 

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Published: 05 Feb 2024, 02:20 PM IST

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