How funds declare dividends

According to latest regulations, funds will declare dividend only if they have surplus income. Does this mean the NAV will not fall proportionately whenever dividend is declared? Recently few dividends were declared and the emails mentioned that the NAV will fall accordingly. How does this work?
-Varsha Kulkarni

Mutual funds declare dividends only when there is a distributable surplus. Dividends reflect distribution of gains and profits. To understand how dividends are declared you need to know where they come from. If an investor enters a fund at an NAV of Rs 12, Rs 10 would go to an account called unit capital account, as the face value is Rs 10. The balance of Rs 2 would go in an account called unit premium reserve. If the invested amount of Rs 12 grows up to Rs 13, the fund can declare a dividend of Re 1 which is the gain on Rs 12, the NAV.

In March 2010, Sebi asked mutual funds not to use unit premium reserve to pay dividends. It was noted that some fund houses were paying dividends from their unit premium reserve instead of the realized gains. Realized gains arise from sale of mutual fund assets or appreciation of assets.

Dividends are paid out from the profits made by the scheme. It is not an additional benefit in this option. The sum gets deducted because you cannot receive the profit as well as let it stay invested in the fund.

So you should see it as a periodic profit booking. Therefore, the NAV of an equity mutual fund comes down by exactly the amount of dividend paid out. Since there is no dividend distribution tax in case of equity funds, this fall in NAV is very precise. Over and above that, the NAV could also be impacted by the change in the equity markets.

This article was originally published on May 15, 2013.