Dividend funds traditionally follow passive fund strategies. These funds tend to limit their portfolio churning and save on the transaction and management costs, while capitalizing on the dividend earnings as the primary sources of returns from the portfolio. The result is a low cost, low risk and a low yield portfolio. Such funds are suitable for investors who have very low risk appetite and would be willing to invest their funds for a very long time. However, in the short to medium term such funds are not always popular; during times of rising interest rates an investor may find that he could get a better yield investing in a debt fund than a pure passive dividend yield fund given the same level of risk. Thus, the popularity of these funds is limited to times when the general economic conditions are down, the business activity is low and interest rates are also falling. This would explain their popularity during these times of economic uncertainty, much like one that has currently gripped the world psyche.
One of the hallmarks of a classic dividend strategy is to invest in dividend stocks which have a consistent dividend track record such as good, established companies with records of strong financial performance. Such companies are usually mid lifecycle stage companies, belonging to established business sectors and who do not face significant growth opportunities and have a large corpus of funds with them which is not very productively employed. It is in part to sustain investor interest in the company and in part to arrest the falling return on capital employed that the management gives away a part of its earnings as dividends. Given these characteristic of such companies it is also ensues that they face limited business risks as well as are least effected by macroeconomic headwinds. Investment in stocks of such companies is thus highly defensive and provides limited upside potential to the investors.
It is possible however, to make some variations in this strategy and do away with a little bit of this safety with a higher potential return. A dividend fund while not losing its overall character can still employ these strategies and earn a better return while still targeting dividends as its soul source of earnings albeit at a slightly higher management and transaction costs. There are companies that are still in their growth phase and have only recently started to give out dividends; they try to balance out their corpus between funding the growth opportunities available to them one hand and rewarding their investors on the other. Such stocks are great opportunities for a dividend portfolio as these stocks may now be available at lower prices, with a rising rate of dividend. Over a period of time when these companies become more established, their prices would have risen and also would have enhanced their dividend payout rates. A portfolio which has held these stocks when they were still in the growth phase would now have a high yielding component which would increase the overall return profile of the portfolio.
There are however two types of risks that can be associated with this strategy. First a growth phase company would not be as consistent in paying dividends compared to an established company and again the payout rates may also vary. Second, the overall returns generated from a fund that includes such stocks may fall in the short run. However, these two risks are only short lived, as the fund which includes in its portfolio a few companies in growth phase will over a period of time mimic the risk profile of a purely defensive dividend fund strategy but with a higher earnings yield. For fund managers who employ this strategy over a period of time, can generate returns that are superior not only to a purely defensive fund but also fixed-income funds.
There are a number of factors that go into building of such a portfolio. First is the selection of the stock and for that also we need to look at the sectors to choose from, the debt-equity profile of the company, the cash generating profile of its business and the geographical or extent to which its business is spread out and the rate of expansion. Second factor that needs to be considered is the proportion of the portfolio that can be allocated to such stocks. Since such stocks also come with a risk element that is higher to that of a pure defensive portfolio, a fund manager has to decide of much of safety he is willing to part with. Third, the manager must be clear about how much current earnings slide he is willing to sustain and finally the tentative time horizon before which the portfolio will be able to track its intended risk profile. The performance of these funds is usually linked to representative earnings of a debt fund, with the manager consistently trying to surpass the performance; however, there are no indices that have been specifically established to benchmark the performance of such funds.
Dividend funds of such types are generally designed as ETFs and are popular with investors who have a moderate risk profile and a very long term investment horizon. Such investors also tend to reinvest their earnings from the fund in the short term to medium term in order to increase the size of their investments so that they may earn a good residual income in the long term when they actually need it. This characteristics of this mixed growth and income funds is not available with the pure defensive dividend income strategies and in the long run an investor making an investment in such a fund with hybrid characteristics could get a return which may even surpass the earnings of a growth fund.
The most important aspect of this type of investment strategy is that an investor is content with lower earnings in the short run for a rewarding future return potential. The beauty of this strategy is that it is able to eliminate risk with time as a component and still give a return that may be as good as a growth fund while still sustaining a low risk profile.
With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities.
Amidst this, are you getting worried about these falling interest rates and wondering where to put your money?
Well! Team Kalkine has a solution for you. You still can earn a relatively stable income by putting money in the dividend-paying stocks.
We think it is the perfect time when you should start accumulating selective dividend stocks to beat the low-interest rates, while we provide a tailored offering in view of valuable stock opportunities and any dividend cut backs to be considered amid scenarios including a prolonged market meltdown.