Can I use index funds to get dividend income instead of stocks?

Published: September 24, 2020 at 12:47 pm

Last Updated on September 24, 2020 at 12:47 pm

A person with a profile name MoneyGita asks if dividend income can be obtained from index funds (or ETFs) after retirement instead of using stocks. Sometimes the answer to a question in personal finance seems like an obvious “no”, but on closer inspection seems, “why not?!”. A discussion.

This is the full message from MoneyGita:  Hey Pattu, Hope you & family are safe and well. I saw you are building a long-term stock portfolio for dividend passive income (see video below) during your retirement. While your way needs semi-active monitoring to maintain the portfolio, I was wondering if this can be done passively as well? I have been toying with the idea.  if there is a passive index way to get the dividends [like investing in a nifty or nifty-next-50 index fund that pays out dividend regularly (quarterly or annually)]. this can serve as a good source of passive income (without much monitoring) for (semi)-retired folks. While this passive dividend approach may not ideal for people in the accumulation phase, but can be a boon for retired people who don’t want to touch (buy/sell) their portfolio. but just enjoy the dividends during their golden years I would love to know your take on this: a) Do Indian investors have any funds/options available in the market? (i see dividend index funds don’t give out dividends regularly as they do in the USA) b) what are the factors and risks to consider if they were to embrace this approach of dividends through index investing? c) what’s your opinion & take on this? Thanks so much for your time. A big fan of your work in the PF space. Keep rocking!

When it comes to a debate on dividend income, the first thing to notice could be the age of the individual. Those less than 40 tend to think “growth” is more important. Those with a decade or more of stock market experience and older tend to appreciate the importance of dividends a lot better. It is a simple matter of priorities! Also see: Should I stop buying dividend stocks since dividends are now taxable?

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As we have demonstrated several times – What percentage of my salary should I invest each month? and What percentage of my salary should I invest each month? – a simple pension is not sufficient during retirement and we need to build ourselves a basket of retirement investment each with a different purpose.

Typical entities in this retirement basket are: (1) a pension for income flooring -see Creating the “idea” retirement plan with income flooring! (2) A portion in fixed income for expenses, emergencies and growth. (3) A portion in equity for growth (4) income sources from real estate (if any!) (5) Skill-based active and passive income (6) dividend income from equity or as suggested here via index or any other mutual funds etc. The choices are easy to list, the difficulty lies in assigning weights to each. We shall consider this in a later article.

There is certainly nothing wrong in allocating a segment of our equity portfolio (stocks or MFs) to dividend income in retirement. Besides the obvious income benefit, it also reduces the risk in the portfolio. At that stage in life, this is of more importance than paying tax on the dividends as per slab (regardless of the amount and be it from stocks or mutual funds).

The differences between getting dividend income from a stock portfolio and a mutual fund portfolio (active or index fund or ETF) should be first considered. When a stock declares a dividend it does so from its earnings.  Each dividend complicates return calculation. See: How to calculate returns from Stocks including dividends.

To get dividend income, the stock portfolio should primarily consist of regular dividend-paying stocks and not growth stocks. When you invest in a dividend mutual fund, the nature of the portfolio is irrelevant. It could be filled with established blue chips or microcaps. The dividend income received by the fund is always put back into the portfolio. The dividend declared by the fund has little to do with the dividend the fund portfolio receives.

If the fund wants to declare a dividend, it has to create a distributable surplus. This means a cash reserve that the board of trustees would approve to be distributed among unitholders. This surplus can be obtained in any number of ways: The fund could sell bonds, stocks or gold. The fund could accrue interest income from bonds or dividend income from stocks etc.

If you simply invest in the dividend option of a fund (regular plan or direct plan), you may or may not receive dividend income. Stocks tend to payout dividend income more regularly due to shareholder pressure and the impact dividends have on market price. A mutual fund does not have such constraints. From this financial year, both stock and fund dividends will be taxed as per slab.

To get regular income from a mutual fund, one will have to invest in the monthly or quarterly or annual dividend plan of the fund. Although the dividend declaration is not a guarantee, the chances under these plans are significantly higher.

Although ETFs have a dividend payout option (these neither have growth or dividend option nor regular plan or direct plan) in their scheme mandate, they are extremely sporadic and for all practical purposes should be treated as growth investments. They are anyway unsuited in retirement due to liquidity constraints.

This leaves us active funds or index funds. Stocks dividends have a certain charm (to those who can appreciate it), but ignoring this as money is money not matter from whence it comes, what are the key differences?

A mutual fund dividend does not rely on dividend from stocks. However, it depends on the funds’ investment policy. Even if a stock trades flat for years, it could still pay out good dividends. If the index is range-bound or if the active funds’ NAV has not moved up much, a dividend need not be declared or it could be small.

Since MoneyGita prefers index funds, let us eliminate active funds – some hybrid funds do declare dividends each month and these are regularly mis-sold to retirees. So do we have any index funds in India that declare regular dividends?

Nippon India Sensex and Nifty Index Funds have quarterly, half-yearly and annual dividend plans. However, I could only see dividend declaration in Feb 2019 and Feb 2020 for these fund in all dividend plans! ABSL Nifty index fund has an annual dividend record but the quantum has fluctuated from Rs. 0.87 per unit to Rs. 5.6 per unit.

The key disadvantage of the stock portfolio which MoneyGita refers to is active management which is not necessary in the case of an index fund. However, in spite of having a dividend plan in their index funds, most AMCs have failed to declare dividends and it has been quite volatile.

Therefore those seeking dividend income as part of a well-diversified retirement portfolio are better off getting from healthy stocks than from a passive fund. Actively managed hybrid funds are definitely more regular and less volatile in the payout but the management cost can be unacceptable for some.

Web story link: Can I use index funds for dividend income?

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