Mutual fund dividends are not free lunch!
A bumper dividend announcement by a mutual fund does not per se merit investment.
The two popular options when it comes to mutual fund investments are: dividend and growth. As you may all know, mutual funds simply use your money to buy stocks, bonds or other investments. The value of investments and cash surplus held in a mutual f
und scheme is reflected in its NAV (Net Asset Value). Time to time fund schemes get dividends or interest payments from these investments. They also make profits on selling some of these investments. Over time, these provide cash inflow for the mutual fund that it can either choose to re-invest by making fresh investments (growth option) or payout as dividend to unit holders (dividend option).
Now let’s take a look at the impact of a dividend or its absence, on the price, meaning NAV of the fund scheme. Let’s say, six months back, a new Equity mutual fund scheme was launched and collected money from investors at Rs. 10 NAV under two options — dividend and growth. Today, the NAV of both the growth option and dividend option is Rs. 15. Due to exceptional performance, the dividend variant of the scheme has decided to book some profits in its investments and share the same with its unit holders. So it’s announced a 25 per cent dividend. i.e. Rs 2.50 per unit.
Now Mr. Ramesh, a mutual fund investor, gets a call from a fund distributor who updates him on this “exciting” news on the very last day for dividend eligibility. Mr. Ramesh, tempted by the idea of reaping quick gains, invests in the dividend option of the scheme, paying Rs. 15 NAV, hoping he would earn Rs 2.50/ Rs. 15, i.e 16 per cent returns. Is he right in expecting this? Unfortunately, no. The next day (the day after the record date), assuming the market remains at the exact same level and all share prices remain unchanged, Mr. Ramesh would be shocked to see the NAV of his investment drop to Rs. 12.50. Why?
This is because a dividend from a mutual fund is nothing but a return of capital held by the fund scheme. The Rs. 15 NAV of the scheme with the dividend option, already included the distributable cash of Rs. 2.50, on distribution of which, as logic would suggest, the NAV reduced by an equal amount. There is no free lunch really! The NAV of the scheme with the growth option would remain at Rs. 15 because the scheme didn’t distribute a dividend. Mr. Ramesh is no better off choosing the dividend option instead of the growth option. And, his purchase decision, triggered purely by the lure of quick returns through the dividend, is a misinformed one.
Every time a fund scheme announces a dividend, the same scenario will repeat, i.e. the NAV of the scheme will drop by an amount equal to the dividend amount. Within the same scheme, the NAV of the growth option will always be higher than that of the dividend option because the money is going back into the scheme and not given to investors. For example, if you were to look at the NAV of HDFC Top 200 equity scheme as on Jul 17, 2009, it is Rs 148.40 for the growth option and Rs 38.30 for the dividend option. The reason for the difference in NAV between these two identically managed plans is that one keeps stripping money and dispatching it to investors while the other just re-invests any gains (income). It is this re-investment that has accumulated and appreciated over time, resulting in a much higher NAV today — a substantial capital gain.
So, is there any difference at all to the investor whether he invests in the growth option or dividend option within the same mutual fund scheme? Yes, their tax treatment.
The enclosed table illustrates the tax implications of dividends compared to capital gains. If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends. On the other hand if your holding period is less than a year, then dividends attract less tax than capital gains.
Taking a long-term perspective, investors who need income can choose the dividend option, although this option neither guarantees the amount of dividend nor the frequency. Past dividends are in no way an indicator of future dividends, but a track record of consistency is favourable. The dividend amount should not be the sole deciding factor while investing, because technically a fund can declare high dividends by merely selling its assets, irrespective of whether it has made a profit or loss! So dividends need to be evaluated in conjunction with the total returns that the fund has been able to generate.
Investors who only need long-term capital gain (wealth appreciation preferred over income) can choose the growth option. Such investors can still pay themselves a dividend when they want liquidity or when they feel the market is overvalued, by simply selling the requisite number of units!
The writer is a finance specialist and a consultant. He can be reached at: firstname.lastname@example.org or www.shyamscolumn.com
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