What the dividend is worth?
These dividends come from the funds' NAV (net asset value) and, therefore, can be likened to redemptions. Suppose you hold 1,000 mutual fund units with an NAV of `20 and the fund house declares a dividend of `2 per share. Since the dividend is coming directly from the NAV, the NAV will fall by `2 to `18. Even as you pocket `2,000 as dividend, the value of your holding comes down to `18,000. Had you redeemed 10% of your holding, the results would have been same-you would have got `2,000 in your hand and your mutual fund holding would stand at `18,000.
While regular dividend from a company shows that its prospects are good, regular dividend from mutual funds means nothing. Given that dividend payouts do not result in any net gain to the investor, why do mutual funds declare dividend? One reason is that funds do it to create a positive perception among investors. Indian investors often confuse mutual fund dividends with company dividends and treat them as a net gain.
Also, booking regular profit and distributing it as dividend in a rising market reduces the risk of equity schemes. In an overheated market, fund managers usually get into cash to reduce the impact of a correction in the market. Now, the question is whether the same should be held as cash in the scheme or should be returned to the investors as dividends? Distributing money to the investors when the fund house feels that the market is frothy and doesn't offer worthwhile investment options is a good move.
Dividend is also useful for investors who need some regular income from their investments. All mutual fund schemes now have a dedicated dividend option. Some investors need regular income, so they choose the dividend option. For them, we try to declare regular dividend out of the profits booked during the year,". Besides the above mentioned factors, fund houses have started declaring `large dividends' to facilitate `dividend stripping' for high net worth investors (HNIs). The normal dividend yield in equity funds is 2-3%; a very high yield, above 15%, can be considered as large dividend. Since large dividends will cause a large fall in the NAV, investors who'll redeem units at lower NAVs will book capital loss--thereby, saving on tax. To stop the rampant dividend stripping strategy, the government has inserted special rules in the Income Tax Act. As per this rule, the loss generated will be recognised only if the investor has held the mutual fund scheme for at least three months before the dividend record date or held it for at least nine months after the dividend record date.
There are also complaints that some fund houses are leaking this dividend information three months earlier, to select HNIs, to circumvent the I-T rule and, thereby, get large fund inflows into their schemes. "To corner large AUM, some fund houses leaked out information in October that they will declare dividend in January. This practice is tanta mount to insider trading and the regula tor should take action in this regard. Can retail investors also benefit when equity mutual funds declare large dividends? Yes. Since dividend from mutual fund is tax free, investors holding the scheme for more than three months can sell and book short-term capital loss and the same can be offset against other short-term capital gains. And even if you have bought these schemes only after the dividend declaration, you can sell them after nine months to book short-term capital loss.
Establish need before you invest
How should long-term investors view dividend declaration? The one-size-fits-all strategy may not work here. Investors need to decide whether they want to invest in equity mutual funds for generating a regular income or for accumulating wealth over the long-term. Accordingly, they need to choose between the dividend and the growth options.
The strategy of escaping tax using dividend stripping will not excite long-term investors because long-term capital gains from equity mutual funds are anyway tax free. So, investors who want to grow their wealth over time have to go for the growth option. And, if they have already opted for a dividend-paying scheme, they need to re-invest the dividend into the scheme. Else, this will hamper their long-term wealth generation and may torpedo critical future goals.
If dividend is the only source of income, it is better such investors move out of equity funds altogether. This is because there is no guarantee these schemes will be able to declare dividend on a regular basis. Since there is a high dividend distribution tax in debt schemes now, dividend option in debt schemes is also not suitable. The effective dividend distribution tax for debt schemes now is 28.84% and it is only slightly small compared to the highest tax bracket (30%).This is a huge price to pay for long-term investors--those with a holding period of more than three years--because long-term capital gains are taxed at 20%, and that too after availing the indexation benefit.
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