Are Mutual Fund Dividends Rewarding Enough?

Dividends distributed by mutual funds are both mis-understood and mis-sold. DSIJ takes a 360-degree view and explains the difference between the two and how to make a right investment decision. 

Many a time, investors consider dividends received from investments in stocks as being same as dividends received from their mutual fund investment. This perception helps mis-selling of the dividend options of the mutual fund schemes to the gullible investors. They consider both dividends as similar and invest in the mutual fund schemes that pay large dividends. The fact is that these two are as different as chalk and cheese and dividends received from your investments in stocks and mutual fund schemes have no similarities. In the following paragraphs, we try to understand both these dividends with a correct perspective, which will help you to take the right decision on opting for dividend option schemes. 

The Difference of Dividend Between Mutual Fund and Stock 

A dividend received from an investment in a stock means the money is paid to the shareholders from the earnings of the organisation. Its not mandatory that every company should declare dividends. The management of the company decides the dividend distribution on the basis of various financial and economic measures. The dividends in the cash forms are usually distributed on a quarterly or yearly basis. All the dividends exceeding Rs 10,00,000 are taxable in the hands of the investor as dividend income at a rate of 10 per cent.In the case of mutual funds schemes, the dividends represent distribution of gains and profits on their holdings All mutual fund houses/AMCs (asset management companies) calculate the dividends for each of their schemes on the basis of the distributable surplus, which is nothing, but the profit booked by the scheme by selling of securities only. It is contrary to the normal belief that dividends distributed by the mutual funds are dividends received by them from holding companies of the scheme. Many times, investors consider that the dividend from the mutual fund schemes are the dividend from the companies underlying the scheme. But the fact is mutual fund dividends have nothing to do with the dividends from its holdings. Mutual fund dividend is separate event and are declared out of profits made by the scheme which is determined by the movement in the net asset value and booking profit. To clarify this let’s have a look at the mechanics of the dividend declaration of stocks and mutual funds. 

Mechanics of the dividend 

In the case of stocks, a company distributes a portion of the profit, which is income in excess of expenses, to the shareholders, taking into consideration the borrowings and assets of the company. It is a sharing of the profits with the shareholders, which is decided by the board of directors. The profit is shared with the shareholders in the ratio of their shareholdings. 

In the case of the mutual funds, dividends are distributed on the basis of the distributable surplus. Distributable surplus is the gain over the face value of the scheme.This is derived from the realized gain from selling of the securities /holdings of the schemes and the unrealised gain that is the profit accumulated but not booked. 

What is distributable surplus 

Distributable surplus is computed by subtracting the sum of face value, unrealised gains and accumulated Unit Premium Reserve (UPR) from Net Asset Value (NAV), where unrealised gains are the profits which are not booked and the total per unit unrealised gains are known as the unit premium reserves. 

Distributable surplus = NAV – (Face value + Unrealized gains + Accumulated UPR) 

Unit premium reserve is calculated by multiplying the unrealised gain component in the NAV by the number of units. Here unrealised gain component is the excess value of the investment over the booked profit. That is the part of the profit on the holdings which is to be realised is unrealised gain component. 

UPR = Units * Unrealized Gain component in NAV 

This shows that the UPR is the total unrealised gain over the number of units of the scheme. 

In March 2010, the market regulator SEBI directed mutual funds that funds should not use unit premium reserve for the declaration of dividend. Prior to this, it was observed that some of the fund houses/AMCs were paying dividends on the schemes from their unit premium reserve (UPR) instead of the realised gains. Realised gains are the gains which arise from selling of mutual fund assetsthat is the holdings of the scheme that can be debt or equity or both. Due to this, distributable surplus for each scheme plan changes, so the dividend declared by the same scheme in direct and regular plan may change.

Price Implication 

Price implication in both the cases remains the same. That is the stock price and NAV corrects depending on the amount of the dividend paid. That is, if a stock is trading at Rs 100 and the company declares a dividend of Rs 1, then on the ex-date, the stock price may correct by Re 1, that is, Re 1 may be reduced from the market price of the stock. In a similar way, the distribution of dividend by a mutual fund scheme will see a corresponding drop in the NAV of the scheme. 

Tax treatments 

Many investors believed that equity dividends were tax-free because stock dividends are subject to DDT (dividend distribution tax) by the companies, and hence double taxation is avoided, which is incorrect. The dividend distributed by a company is altogether different from the dividend distributed by a mutual fund. The dividend distributed by a mutual fund house and that distributed by a company are two different transactions and hence can be taxed differently. 

In the case of dividends declared by the companies, the DDT, that is dividend distribution tax, is the company’s responsibility. However, in the case of the mutual funds, the DDT is calculated and deducted from the NAV. Also, the DDT accounts for more than 10% with the addition of the surcharge and cess of 12 per cent and 4 per cent, respectively. So, the dividends of a mutual fund scheme reduces the value of investment, which in a way is a loss for the investors even if they are getting regular income. So, post-DDT, the dividend option for a mutual fund scheme may reduce their returns and may not lead to wealth creation. 

Implications for investors 

Regular dividends from a company represents a healthy balance sheet of the company. However, regular dividends from a mutual fund scheme many not necessarily lead to such a conclusion. Many times, a mutual fund scheme may return the investments of the investors in the form of dividends, so there is no net gain from it. Let us see this with an example. If an investor invested the same lump sum amount on the same day in the same fund’s growth and dividend option plans, this is how his returns will look like, which is an actual case of fund distributing higher dividends. One can observe that in the dividend option, even after getting regular dividends, the returns are quite lower than the growth option. 

After observing this, the first question that comes to mind is why AMCs declare dividends regularly. One basic reason behind this can be that the fund houses are aiming to meet investors' demands or requirements and want to create positive perception among the investors about getting regular income. 

So investors should look at the holdings of the scheme when the scheme distributes the dividend to find out whether the fund manager is making profit or just wants to distribute dividend out of the fund corpus. 

Conclusion 

After knowing the differences in the dividends declared by the company and dividends declared by mutual fund houses, the question that comes to mind is: should you opt for the dividend option? Before answering, let us just look at some myths about dividends which will be busted by us and then move on to the decision part. 

The first myth is frequent dividends are considered as an indicator of the fund's performance. But as we have seen earlier, frequent dividends from mutual fund schemes are nothing but profits made from selling securities, which is then distributed and which lowers the NAV of the fund. So frequent dividends cannot be an indicator of the performance of the mutual fund scheme. Second myth is that the lower NAV of the dividend plans is a good measure to select them as it suggests a buying opportunity. 

However, the fact is that the lower NAV is going to get more and more attractive every time the scheme declares dividend. Third myth is that a good track record of dividend can be a parameter to select the scheme as dividends are not mandatory and if the scheme makes profits only then the fund house can declare dividends. 

However, past track record of dividend distribution does not guarantee that dividend will be declared with the same frequency in the future. Due to this, it is very clear that dividends cannot be considered as regular incomes. 

So, if your ultimate aim is to grow your wealth over a period of time, then dividend option of the mutual fund scheme is no more effective post imposition of the DDT. As for the regular income from mutual fund in the form of dividends, SWPs (Systematic Withdraw plan) can be more efficient than the dividend option, as it can also maintain the return yields.