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Mutual Fund Dividends: Playing with your own money

Some mutual funds offer dividends and then put up big advertisements about them, to the lines of “XXX mutual fund offers 260% dividend on [a future date]”. They expcct you to buy the fund before the date of dividend, and think you will get really excited about the dividend. But should you be?

Some background
If you don’t know what dividend means, read this article first.

Mutual funds are collective investment vehicles, with a fund manager investing your money for you. Dividends are payouts by the mutual funds to investors. Now dividends are PART of the net asset value, so after the dividend the net asset value goes down by the amount of dividend!

Assume you have 100 units of a mutual fund whose NAV is Rs. 50. This fund declares a 50% dividend (50% is always on the face value of Rs. 10, so this means Rs. 5 per unit)

What do you get? 100 units x Rs. 5 per unit = Rs. 500. The Net asset value will now go down by Rs. 5 per unit, and will now be Rs. 45. So your units will be worth Rs. 4,500 and the cash you get will be Rs. 500, so your net value still stays Rs. 5,000!

Unlike mutual funds, in stocks, things may be different. Dividends are paid out of cash profits of a company, so when a company declares a dividend it is far better (because the cash of the company may not be taken into consideration in its market price). So when a company declares dividends, it may be worth considering because of the hidden value that has now been recognised in the form of dividends.

Mutual funds have no such “unrecognised” value – Net Asset Value means the current value of ALL assets of the mutual fund! This is calculated by multiplying the number of shares or instruments held by their market prices, adding any cash holdings, and subtracting any liabilities. There is no “hidden” value in the fund that you can cash on.

But aren’t dividends tax free?
Yes, equity funds (that have more than 65% in the equity market) declare tax free dividends. But investing in a fund purely for dividends is stupid, because it’s your own money coming back to you. Plus, you have to pay entry loads.

If you still think dividend are great, I have a proposal for you. Give me Rs. 100,000, out of which I will take Rs. 2,250 as charges (2.25%). Out of the remaining Rs. 97,750 I will give you Rs. 50,000 as dividend! The remaining Rs. 47,750 is with me for you to take whenever you want. Do you like this idea?

Obviously not. It’s just like throwing away Rs. 2,250. But if I am a fantastic fund manager, you may invest because I may give better returns than anyone else! In that case, I should be investing the money, not giving it right back to you. So, choose funds that you think will perform well, that have done well in the past, and that seem to have the risk-reward equation that you are comfortable with. Don’t invest for dividends.

Dividend stripping laws
Some of you may think, in the above example, that “If I buy some units for Rs. 50, then get a dividend of Rs. 5, I can immediately sell the units for Rs. 45. Then I will tell the tax department I made a loss of Rs. 5 per unit, and that loss will offset any short term gains I made elsewhere. I’ll get the dividend tax free so technically there is no loss. I’ll gain on the income tax I would have otherwise paid!”.

The Income Tax Department was not born yesterday.

There is a rule that specifically disallows short term losses if you buy three months before a dividend date and sell within 9 months after. This is the “dividend stripping” law, so you can’t take advantage of dividend declarations for tax saving.

And what about this 1000% dividend and so on?
Remember that a fund cannot declare a dividend greater than it’s NAV! If a fund’s NAV is Rs. 140 per unit, it cannot declare a dividend of Rs. 150 per unit.

So what is this 1000%? It’s based on the face value of a mutual fund unit, which is usually Rs. 10. So 1000% means Rs. 100, and 50% means Rs. 5. The unit of the fund may be much higher than Rs. 100 or Rs. 10!

ELSS funds?
Well, there is a small advantage in getting dividends in locked schemes like ELSS, where funds are locked in for three years. Read more about it: Beware of dividend pushers.

Overall, be aware of what dividends mean in mutual funds. Don’t jump in salivating at the prospect of a dividend: it is just your own money coming back to you with no extra gain.

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