Dividend yield funds: Balance risk/return

SMART PERFORMANCE

Even though dividend yield funds have been around for a while,investors have still not entirely warmed up to the concept. Although the assets of these funds have risen over the years,they still constitute less than 3 per cent of equity fund assets at the end of 2010.

However,performance of these funds have picked up smartly in recent times,especially amidst volatile markets. Even though it would not be advisable to just look at the one year returns,a quick glance at the same would bring to the fore that most dividend yield funds have topped the charts within their respective categories over this time frame. This is despite the fact that these funds maintain higher exposure to mid- and small-cap stocks,which have been battered in the recent correction. The performance over longer periods like 3 years and 5 years is also impressive.

Lets now analyse how dividend yield funds have typically fared in bull and bear market phases compared to other diversified equity funds in the country. During the 2008 financial crisis,dividend yield funds delivered an average return of -49 per cent,while diversified equity funds fell by an average 56 per cent. The BSE Sensex and Midcap indices returned -53 per cent and -67 per cent respectively in the same year. Even in the recent market correction between November 5,2010,and February 10,2011,which saw the benchmark sensitive index losing close to 17 per cent and the BSE Midcap index plunging close to 27 per cent,dividend yield funds managed to restrict some losses and fell by an average 17 per cent. A typical diversified equity fund fell by close to 20 per cent over the same period.

Meanwhile,a look at past bull market years of 2007 and 2009 reveals that dividend yield funds have managed to provide decent gains to investors,and in some cases even top quartile returns when compared to other diversified equity funds. However the year 2006,was quite a dismal year for these funds as most of them finished the year in the bottom ranks among other diversified equity funds.

HIGHER ALLOCATION IN STATE-RUN FIRMS

A look at the portfolios of these dividend yield funds would indicate that most of them are heavily loaded up with mid- and small-cap stocks. Of the eight dividend yield funds in the market,six belong to the Morningstar India Small/Mid Cap category. Only two funds belong to the large-cap category. A deeper review of their portfolios shows that these funds are overweight in certain sectors like financial services especially PSU banks,consumer goods FMCG and auto,utilities and even to some extent in energy.

Also,a point to note would be that dividend yield funds usually have higher allocation in stocks of government-owned companies,which are believed to have more dividend yield potential. Many of the above mentioned sectors have been outperformers over the past one year,and some of them like FMCG and utilities have turned out to be good defensive plays as well in volatile markets.

PROTECTION IN MARKET DOWNTURNS

Even though dividend yield funds havent managed to catch the fancy of investors entirely,they have been able to reward investors with good enough returns,and at the same time protect them from market downturns. The Morningstar five-star and four-star ratings secured by most of these funds further stand testimony to their superior risk adjusted performance over longer time frames. With Indian equities not looking as attractive in 2011,as compared to previous years,dividend yield funds could turn out to be a suitable alternative for the more conservative investors who are wary of volatile equity markets and want to limit their downside risk.

Author is Senior Research Analyst,Morningstar,India