In an email we received a few days back, an investor asked my opinion about a fund he?d chosen to invest in. The fund he had picked was a well performing equity diversified fund, and his query was regarding the two options the fund offered ? growth and dividend. The investor said in his email that he had picked the dividend option because he wanted that ?something extra? from the fund as well. This, I believe, is not a one-off case. Most investors seem to be confused by the dividend payout option of an equity fund.
Let me make this clear ? the dividend that a fund pays out is not something extra that you?re being given. The dividend is nothing else but a part of your investments in the fund. It is just a redemption that is called dividend. To pay this dividend, the fund management just sells off a part of your investments in the dividend plan.
Here is how the dividend is paid to investors: suppose you own a 1,000 units of a fund with an NAV of Rs 20, your investment would be worth Rs 20,000. If the fund then declares a 10 per cent dividend, your total dividend amount would come to Rs 1,000 (since you own a thousand units). This Rs 1,000 that you would receive as dividend wouldn?t be something extra though. It wouldn?t mean that you have received Rs 1,000 but your investments are still worth Rs 20,000. In fact, your investments would be reduced to Rs 19,000 because to pay the dividend, the fund would deduct the amount from your investments only. Hence, the NAV of the fund would also fall to Rs 19. This is how fund dividends are paid out, they are just your investments given back to you.
This is where most investors make investment mistakes. Mutual fund dividends are compared to share dividends, but the truth is that they are completely different things. Share dividends are a bonus, fund dividends are not. An investor should choose a dividend option of a fund only when he wants a certain part of his investments redeemed to him at definite periods. The other reason to choose a dividend option is the tax benefits. The dividend income from equity funds are tax free. If you invest in a fund and immediately get part of the investment back as dividend then you’ll have a loss on your capital. However, if you hold onto an investment for at least three months, it would qualify for a tax set-off with that loss.
But choosing a fund?s dividend plan to get a bonus is a misconception that makes investors take wrong investment decisions. In fact, fund companies are as much at blame for this as investors. Giving out dividends has been a standard method adopted by funds to attract fresh investments. Fund companies declare dividends in an attempt to lure investors towards their fund because investors live under the belief that the fund which declares big dividends is better than its peers. The problem also lies in the terminology. Share dividends are associated with bonuses and one can?t blame a lay investor for believing the same to be the case with fund dividends.
Sebi has been doing its bit to make fund investments lucid, but while this problem is rectified, investors should keep themselves abreast about the nuances of fund investments to avoid falling into traps.
Author is CEO of Value Research