The strategy has the potential to outperform the market as a whole, but stock selection should not be made on the basis of dividend profile alone to optimise the risk and return available.
Decreasing the risk
Consideration should always be given to all available company information, such as the quality of the balance sheet, cash flows and growth prospects. Companies that pay higher dividend yields on a sustained basis tend to operate in mature established industries. This can make them less volatile and not as high risk as others, but it is still important to diversify geographically and across sectors to decrease the overall portfolio risk.
Investing through a fund has some noteable advantages over directly purchasing the same underlying assets. Firstly, by investing in a collective fund an individual can cost-effectively gain exposure to a broad selection of stocks.
Typically, a fund would have a minimum investment amount, but this investment would gain exposure to the performance of the whole portfolio within the fund.
Except for very large investments, it can be difficult to cost-effectively purchase the same diverse range of stocks directly.
Taxation of funds
The taxation treatment of funds is also a major factor in deciding whether it is suitable to invest in this way, and is particularly important in relation to investing in equities with a high dividend yield.
While different classes of investor are subject to differing tax regulations, and everybody’s individual situation is different, investing in a high yield equity fund would generally be considered more attractive from a tax perspective than direct investment.
Dividend income received by an individual is liable to income tax at that person’s marginal rate.
This can impact on the attractiveness of high yielding equities, particularly for those investors paying income tax at the higher rate as this is significantly higher than the tax rate chargeable on capital gains. Direct investment in equities therefore carries this potential drawback.