What are dividend yield mutual funds and how do they work?

Investing can have many objectives. One common goal for investors is to potentially build wealth over time. But the potential to generate regular income can also be an appealing option.

A mutual fund category that can cater to the latter objective is the dividend yield mutual fund. Dividend mutual funds are a category of equity mutual funds investing predominantly in dividend yielding stocks.

This article tells you more about dividend yield mutual funds and factors you should keep in mind if considering investing in them.

Table of contents

• What are dividend yield mutual funds?
• Features of mutual funds for dividends
• How do dividend mutual funds work?
• How should you invest in a dividend option in mutual funds?
• Why should you invest in dividend paying mutual funds?
• Taxation rules of dividend mutual funds
• Factors to consider before investing in dividend paying mutual funds

What are dividend yield mutual funds

The mutual fund schemes that primarily invest in stocks or securities offering high dividend yields are known as dividend yield mutual funds. Such mutual funds for dividends usually focus on companies that have a track record of paying regular dividends. Such companies also tend to well-established and profitable companies.

It is important to note that dividend yield funds are different from or dividend option in mutual funds. The dividend option is the earlier name for Income Distribution cum Capital Withdrawal, which is a facility where a part of a mutual fund’s distributable surplus (which could include dividends, capital gains and more) can be released to investors at intervals, at the discretion of the fund manager.

In comparison, these dividend yield mutual funds refer to a specific category that invests in dividend yielding stocks. Those dividends (along with other capital gains and income) may be passed on to the investor if they have opted for the dividend option in mutual funds via IDCW. If investors have chosen the growth option, those gains, income, dividends etc will stay invested.

Features of mutual funds for dividends

• Income generation: The primary appeal of dividend paying mutual funds is their potential to generate regular income for investors. The dividends received from these investments can be distributed to the investors of the fund.
• Growth potential: If reinvested, these dividends can increase the mutual fund portfolio value, resulting in more opportunities for compounded growth potential.
• Relatively low volatility: Dividend yield mutual funds tend to be less volatile than growth-focused funds because they invest in stable, dividend paying companies. This feature appeals to conservative investors seeking stability and a predictable return potential.
• Value investing strategy: Dividend yield mutual funds look for companies with a strong history of paying dividends and with solid growth potential. They often focus on sectors known for regular cash flow, such as consumer staples, utilities, telecom, and financial services.

How do dividend mutual funds work?

The fund manager of high dividend yield mutual funds selects established companies from across sectors known for regular dividend payouts. The fund receives dividends from these companies and can either distribute them to investors or reinvest them in the market to access further growth potential.

How should you invest in a dividend option in mutual funds?

When looking to invest in a mutual fund for dividends, you must choose a fund that aligns with your income goals and risk tolerance. You can invest via a Systematic Investment Plan (SIP) for disciplined investing or lump sum. Ensure you understand the tax implications.

Why should you invest in dividend paying mutual funds?

Here are the benefits of investing in dividend yield mutual funds:

• Regular income potential: They provide a steady cash flow which makes them suitable for income-seeking investors.
• Diversification: By pooling investor money into a broad selection of dividend paying mutual funds, they offer diversification and mitigated individual investment risk.
• Capital appreciation potential: While the primary goal of investing with dividend option in mutual funds is income generation (through dividends), capital appreciation is also possible if the dividends are reinvested. These reinvested dividends, coupled with an increase in stock prices, can enhance opportunities for potential growth.

Taxation rules of dividend mutual funds

Dividend paying mutual funds are taxed like other equity funds as per Budget 2024 as follows:

• Short-term capital gains (STCG) tax: All short-term capital gains from dividend paying mutual funds are taxed at 20%.
• Long-term capital gains (LTCG) tax: Long-term capital gains higher than Rs. 1.25 lakh per financial year from dividend mutual funds are taxed at 12.5%.
• Dividend income: Added to the investor’s total income and taxed at the applicable slab rate.

Factors to consider before investing in dividend paying mutual funds

Once you are clear about your investment goals, you must consider these factors before investing in mutual funds for dividends:

• Assess your needs: Evaluate whether you need regular income or long-term growth potential. If you see the latter, the growth option or other mutual funds geared towards generation capital appreciation potential may be more suitable.
• Dividend sustainability: Analyse the fund’s portfolio to assess the dividend-yielding potential of the underlying stocks in the mutual funds for dividends.
• Expense ratio: Compare the management fees of the dividend yield mutual funds you have shortlisted to find the one with a lower expense ratio for enhanced net returns.
• Diversification: Ensure broad sector exposure when making an investment in dividend yield mutual funds.

In conclusion, mutual funds for dividends can be suitable for individuals seeking regular income potential along with capital growth in the long term. They can be considered by retirees looking for steady cash flow or those who seek a secondary source of funds.

FAQs:

Can dividend paying mutual funds be a source of passive income?

Mutual funds for dividends can be a source of passive income in India, potentially providing routine payouts. However, the actual disbursal of income depends on the performance of the underlying stock, the asset management company and the distributable surplus available to the fund manager.

What is the minimum investment I should make in a high-dividend mutual fund?

Minimum investment amount in many mutual fund schemes (Systematic Investment Plans as well as lumpsum) start at Rs. 500 per month.

What kind of returns can I earn from dividend mutual funds?

Mutual funds for dividends typically offer annual returns based on the portfolio performance and market conditions. Returns vary based on market trends and broader economic factors.

Are dividend yield funds a good investment?

Dividend yield funds can be a suitable investment for investors with a high risk tolerance looking for the potential to earn income from their investments or optimise return potential by reinvesting dividends released by the underlying companies of a mutual fund portfolio.

Where do dividend yield funds invest?

Dividend yield funds invest stocks of companies that tend to have a higher dividend yield. Dividend yield is a measure of how much a company pays in dividends annually relative to its stock price. Such companies also tend to well-established and profitable.

Should I invest in dividend yield mutual funds?

You may consider dividend yield mutual funds if you seek the potential for regular income or for long-term capital growth. Do note, however, that dividend payments by stocks will depend upon the performance and decisions of underlying companies. Additionally, IDCW payouts will be made at the discretion of the fund house.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.