Foundations

# The Dividend Yield Strategy for Mutual Funds

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There is an interesting way to make better use of mutual funds. The Dividend option of mutual funds offers money to investors regularly, and the growth option provides only capital appreciation. In shares, dividends come out of free cash in the company’s hands, and out of their net profits; in funds, all free cash is part of the net assets of the fund, so it’s simply your money that’s being given back to you. In a growth fund, you can sell units to get the same money.

Usually dividends are declared as Rs. per unit (like Rs. 1.5 per unit). So is it better to buy funds of a smaller NAV so that, for the same corpus, you can get a much larger number of units, and therefore, larger dividend?

Dividend or units, they are both “your money”. If you buy 5000 units for 10 rupees or 1000 units for 50 rupees, it’s the same thing – dividends that come reduce your NAV to that extent so your net value is the same. Let me give you an example: Let’s say you own 5000 Rs. of Fund A at 10 Rs., and 1000 units of Fund B at 50 Rs. each.

Fund A : 5000 x 10 = 50,000
Fund B : 1000 x 50 = 50,000
Cash : Zero (it’s all in the funds)
Total: Rs. 100,000

Let’s say both give a dividend of Rs. 2 per unit.

Now you will get Rs. 10,000 from Fund A, whose Nav will go down to Rs. 8 per unit.

And you will get Rs. 2,000 from Fund B, whose NAV will go down to Rs. 48 per unit.

Fund A: 5000 x 8 = 40,000
Fund B: 1000 x 48 = 48,000
Cash : 10,000 + 2,000 = 12,000
Net worth = 100,000

Both ways your net worth remains the same.

So if you wanted money from Fund B you could sell some units and get the money (as much as dividend falls short).

But there is a caveat: Dividends are totally tax free, and for equity funds, zero dividend distribution tax applies. All the money you get through dividends is exactly that value – no tax is paid and no charges are paid.

Selling fund units involves 2 charges: A 0.25% STT charge during the sale, and potentially, a 10.2% short term capital gains tax if you sell within a year. That’s a fairly big hit on your money, if you need it in the short term (within a year of investment). Even after a year, the Higher-units-more-dividend strategy pays off to the extent of the STT (0.25%) – small, but could be significant when you consider 10 lakhs or more (STT will be Rs. 2,500 for that amount).

Having said that, this strategy will only work if the dividend given by a smaller NAV fund is as much as that of a higher NAV fund. That means you have to compare “dividend yields” i.e. dividend divided by NAV. This is usually much smaller than the “50% Dividend” type of announcements that funds make – such percentages are of the Par value (Rs. 10) and not the current NAV! A “50%” Dividend is equal to Rs. 5, but on a Rs. 50 NAV, the yield is only 10%.

Let’s see some recent dividend announcements:

 Dividend Div. date Dividend Pre-nav Yield UTI Petro Fund (D) 1/12/2006 2 20.03 9.99% Franklin FMCG Fund (D) 29/11/2006 3 25.44 11.79% Franklin India Oppor. (D) 29/11/2006 3 18.66 16.08% Franklin Infotech Fund (D) 29/11/2006 1.5 25.56 5.87% Magnum Comma Fund (D) 27/11/2006 1.5 14.56 10.30% Sundaram Select Focus (D) 24/11/2006 3.5 16.25 21.54% LIC MF Index – Sensex Plan (D) 22/11/2006 5 18.58 26.91% Franklin India Prima Plus (D) 15/11/2006 6 38.95 15.40% Reliance Growth Fund (D) 30/10/2006 2.5 54.63 4.58% Sundaram Select Midcap (D) 27/10/2006 4 20.94 19.10%

Note: NAVs are pre-dividend.

You’ll notice that the LIC Index Fund has the best yield – 26% at a (predividend) NAV of 18.58, and that is even better than the Magnum Comma fund whose NAV is lesser (14.56) but yield is only 10.3%.

You should choose funds with the best dividend yield. (Remember of course that dividends are only past performance, and may not be repeated in future. You should choose good fund houses where you are confident of their dividend disbusements in future)

Such a dividend yield strategy should only be chosen if you want cash flow, i.e. money to be constantly returned from your investments. Most equity funds pay money twice a year, and if you use this strategy, you can ensure that you get money to pay off your annual payments, like insurance premiums, property tax or even income tax.

Also, you should choose funds with consistent dividend payments. LIC MF Index Fund (Sensex Plan) has announced dividends in Nov 06, Jan 06, Jan 04 and Nov 03; no dividends from Jan 2004 to 2006. This makes it a very erratic dividend payer. That would destroy your cash flow!

No mutual fund site in India provides historical dividend yields and analysis. Maybe I should start working on this as well (I am in the process of defining a site that will help you figure out what works best).

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