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The Dividend Dead End

With entry load ban deadline looming, mutual funds looked to lure investors by paying dividends

By the time you read this article, entry loads charged by mutual funds will be history. From August 1, fund sales distributors will be paid directly by investors rather than being paid by funds out of the entry load. We'll be talking about the impact of this change as things become clearer, but for the time being, there are some very interesting things that have happened during the past few weeks -- the period between the Securities and Exchange Board of India’s (SEBI) announcement that entry load was being abolished and the day that it actually got abolished.

As soon as it became clear that entry load was on the way out, fund companies got down in earnest to collect as much investments as was possible before the deadline. Clearly, distributors won't sell without some kind of upfront fee from funds and if they can't be paid out of entry load then they'll have to be paid out of the fund companies' own slice of the pie and that'll mean lower profits for everyone around.

This race for gathering assets took two forms -- new fund offers (NFOs) and dividends. While the NFO story is clear to everyone, many investors need to understand a little more about dividends and why mutual fund dividends are meaningless from an investment returns point of view.

July saw a bonanza of dividends in equity funds. As many as 35 equity funds announced dividends. Apparently, announcing a dividend works effectively as a sales-boosting gimmick. The only reason why this should be so is that investors do not understand the nature of mutual fund dividends and confuse them with corporate dividends. A mutual fund dividend is nothing but a redemption in disguise. For the dividend-paying plan, funds simply sell off part of the assets and pay out of the proceeds.

Here's an example of the maths. Let's say you own a thousand units in a fund with an NAV of Rs 20. Your investment is worth Rs 20,000. The fund announces a dividend of 20 per cent. That's 20 per cent of face value, which is Rs 10, or a dividend amount per unit of Rs 2. For your thousand units, you'll get a dividend of Rs 2,000. However, this amount will come straight from the value of your investment. On the record date, the NAV of the fund will drop by Rs 2 to Rs 18. This means that along with receiving Rs 2,000 as dividend, your investment will be worth Rs 2,000 less. Getting mutual fund dividend is a zero-sum game. Dividends have no impact on the return you are getting from your investment. What that means is that those who are investing in funds on getting attracted by dividends are just going to lose the 2.25 per cent that funds will charge as entry load and have some of their money rotated back to them.

In equity mutual funds, dividends can play a role in tax planning since equity dividend income is tax free. If you invest in a fund and immediately get part of the investment back as dividend then you'll have a loss on your capital. However, one has to hold an investment for at least three months to qualify for a tax set-off with that loss.

The most important things is the basic non-dividend nature of mutual funds' dividend and that's something that investors must understand.