The Telegraph
Monday , June 4 , 2012
Since 1st March, 1999
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Pick for all seasons

In a tough economic climate, taking the right investment decisions is a big challenge. A safe-haven investment in gold is quite expensive right now. Though bank deposits and bonds currently yield 8-9 per cent, the post-tax returns are much lower. Holding on to cash is also not worthwhile when inflation is galloping at an annual rate of over 7 per cent. In such a situation, what options are you left with?

Don’t shoot back at this, but equities, particularly high dividend yield stocks, can be a good bet. Though few buy shares for dividend income (people in our country generally buy shares for capital growth rather than dividend income), high dividend yield stocks can prove to be a good diversifier when the country’s GDP growth rate is at a staggering 9-year low and interest rates are high.

The basic characteristic of high dividend yield stocks is that these companies have large cash flows but don’t have a huge debt burden because of which they can pay large dividends year after year.

But direct investing in stocks that pay high dividends is not easy. The alternative is dividend yield mutual funds.

Superior return

Dividend yield mutual funds — equity mutual funds that invest predominantly in stocks with high dividend yield — are around for quite some time. The country’s first such fund, Birla Sun Life Dividend Yield Fund, was launched in February 2003. After that a handful of other fund houses launched theirs, but such funds have not really caught the fancy of investors.

These funds (see chart) have given a much superior return than Sensex or Nifty over 1 year, 3 years and 5 years. Even the returns are better than the average return of large cap, diversified equity mutual funds over the same time period.

On a one-year time frame, when markets exhibit high volatility, the losses from dividend yield funds are much lower than equity indices.

Linked to profit

According to market research and credit rating agency Crisil, dividend yield funds can act as a defensive strategy for investors in the current volatile equity markets.

Let us see why dividend yield funds work better in bad times. Dividend payment by a company to its shareholders is not linked to its share price movements, but to the profitability of the company. So, irrespective of share prices going up or down, a high dividend paying company always rewards its shareholders. As such, share prices of such companies fall less compared with other companies when the markets tumble.

“Dividend yield funds follow the ‘value style’ of investing,” said Mukesh Agarwal, senior director, Crisil Research. These funds invest in stocks that pay high dividends but are available at low prices, resulting in a high dividend yield at attractive valuations.

“Dividend yield funds thus get the dual benefit of income from dividends announced by the underlying companies in the investment portfolio and capital appreciation due to the rise in share prices of these companies,” Agarwal explained.

No other asset class can give as high a return as equities over a long period of time. This is so because in a developing economy like ours the GDP (gross domestic product) growth is high.

If we assume a 7 per cent GDP growth and an annual inflation rate of 6 per cent, the nominal GDP growth works out to 13 per cent. A 13 per cent nominal GDP growth means at least a 15 per cent profit growth for companies. In other words, one can safely expect a 15 per cent annual return on equity investments.

Patience counts

Sure, equity investments are fraught with risks. But these risks get evened out over a long period of time, say seven or 10 years.

After all, equities are not the place you should be in if you want to become rich overnight. You just need to be patient and disciplined. When you consider investing in equities, invest regularly and invest only that much amount that you may not need for at least 10-12 years.

The next question then is how to create a balanced investment portfolio. Your equity investments should consist of a core portfolio consisting of a large-cap diversified equity mutual fund that has a good, consistent track record over a sufficiently long period of time, say 10 years. This core portfolio is then topped with a dividend yield fund and a small and mid-cap equity fund. A small and mid-cap fund ensures faster growth of your investment. Once you have this fund mix in your kitty, you can rest assured that equities won’t disappoint you.

Switch to avoid loss

When markets turn tumultuous, switch your investments from small and mid-cap equity mutual funds to dividend yield funds. This will restrict the erosion in your investment. When markets fall, share prices of small and mid-cap companies plunge more steeply. A switch to dividend yield funds will stem this fall first by the high dividend income from companies in which it has invested and second by a smaller decline in the share prices of high dividend paying companies.