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The Dividend Drawback

The habit of the mutual fund industry to pay dividends takes undue advantage of investors' shallow knowledge

One of the most persistent confusions that mutual fund investors have is with the concept of dividends. Many fund investors seem to think that a mutual fund dividend is some sort of a bonanza, an extra bit of money that comes their way because of something special the fund has done. This is not a fringe belief, yet it is so pervasive that giving out dividends has long been a standard method of attracting new investments among fund companies. I have been told by senior sales people of more than one fund company that they even work out thumb rules to figure out how much dividend payout will bring in what amount of fresh investments under which conditions.

This propensity to choose funds based on their dividend payments is a major problem. It is a completely spurious factor with absolutely no merit in it. The only reason why this belief persists can well be that investors do not understand the arithmetic of mutual fund dividends and confuse them with corporate dividends. A mutual fund dividend is basically redemption of your investments in a fund. It (redemption) just happens to be called a dividend. To pay this dividend, the management simply sells off a part of the assets held in the dividend plan of a fund and pays off the proceeds as dividend.

Here's an example of the accounting. Let's say you own a thousand units in a fund with a net asset value (NAV) of Rs 30. Your investment is worth Rs 30,000. The fund declares a dividend of 10 per cent. That's 10 per cent of the Rs 10 face value of each unit. Thus, the dividend is Re 1 per unit. Since you own a thousand units, your total dividend amount comes to Rs 1,000. However, this money will simply be deducted from the residual value of your investment. To pay the dividend, the fund will sell off an appropriate proportion of its assets. When the dividend is paid out, the NAV of the fund will drop by Re 1 to Rs 29. The end result is that when you receive Rs 1000 as dividend, the value of your investment goes down from Rs 30,000 to Rs 29,000. Dividends have no impact on the return you are getting from your investment. 

Receiving dividends does have a tax implication. 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 thing is the basic non-dividend nature of mutual funds' dividend and that's something that investors must understand. Perhaps the problem is in the nomenclature. Till a few years back, new fund launches were called initial public offerings (IPOs). Then the Securities and Exchange Board of India (SEBI) forbade the use of that term because it led investors to mistakenly believe that new fund launches shared some of the characteristics of new stock offers. Now, new fund offers are called just that - NFOs.

While a similar renaming is unlikely in the case of dividends, knowledgeable investors should stop themselves from choosing funds on the basis of payouts.