Protect downside risks to your folio with dividend yield funds

They tend to decline less than the benchmarks in a falling market and also offer sound risk-adjusted returns across cycles

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

Surging crude oil prices have emerged as a critical risk that could worsen India's fiscal deficit, current account deficit, and inflation numbers this year. Several state elections followed by the general elections of 2019 could create political uncertainty. Risks could emerge globally from faster-than-anticipated rate tightening by the US Federal Reserve, trade war between the US and China, and geopolitical tensions vis-avis Syria, North Korea, etc.

After five-six years of single-digit growth, earnings growth is improving, and there are forecasts of doubledigit growth for 2018-19. But based on experience, you should take them with a pinch of salt until they materialise. The Nifty is up 0.32 per cent year-todate, off 5.08 per cent from the year’s peak value on January 29.

Dividend yield funds manage to provide downside risk protection since 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 dividends in the future, which in turn means that these companies are expected to see an increase in earnings,” says Swati Kulkarni, executive vicepresident 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 has got re-rated, as happened after 2013, this style tends to underperform vis-a-vis 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 beat their benchmarks consistently ( 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 largecap oriented while others are mid-cap dominated. Owing to the higher current valuations of mid-cap stocks compared to large-caps, the former could also correct more sharply, and hence prove more volatile. Avoid funds with a high allocation to smaller companies. “Smaller companies lack the ability to announce dividends regularly,” says Nikhil Banerjee, co-founder, Mintwalk.

Take a 10-20 per cent exposure (of your 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 may use them opportunistically, when the markets are volatile.