Sebi?s new notifications for mutual funds?particularly in regard to distribution of dividends?are welcome. What it has effectively done is made fund managers distribute dividends only to the extent of the returns made. And nothing more. In the past, some mutual funds have been known to declare hefty dividends only to entice new customers. Often, this dividend had little correlation with the funds? performance. But investors often fell for such a strategy?associating hefty dividend declaration with superior performance.
The new regulatory norms would ensure that the fund manager doesn?t dip into fund capital of the scheme to pay hefty dividends. The new Sebi rule states that unit premium reserve cannot be used to pay dividends. Unit premium reserve is the equivalent of share premium reserve (that gets a mention in the balance sheet of companies issuing equities). Previously, the unit premium reserve of mutual funds was considered part of distributable surplus, the corpus that is exclusively used to declare dividends. And hefty dividends were paid from these.
For instance, if you invested Rs 10,000 in Fund A on the day of the NFO (Mar 2007), at a par value of Rs 10, you would be allotted 1,000 units of the fund. Assume that after two years the fund NAV appreciates to Rs 30 (March 2009), during which another investor puts Rs 30,000 into the fund. In this case, the other investor would also be allotted 1,000 units (30,000 divided by 30).
Now, suppose a year later the fund NAV surges to Rs 40 and fund managers plan to declare dividends. Simple logic suggests that dividends shouldn?t be more than Rs 30 (NAV gain) for you and Rs 10 (NAV gain on an NAV cost of Rs 30) for the second investor. Otherwise, it would mean dipping into the capital.
Yet, as per the old rules, the fund manager had the leeway to declare dividends of up to Rs 30. This was possible because when the second investor invested at a NAV of Rs 30, Rs 10 was considered as unit capital and Rs 20 as unit premium reserve. And Sebi allowed the unit premium reserve to be part of the distributable surplus, from which dividends are paid.
But if Rs 30 is declared as dividend, it is tantamount to dipping into capital for the second investor. This is because he would have invested Rs 30,000 into the fund which is today quoting at Rs 40,000, but the fund manager has thought it appropriate to distribute Rs 30,000 back as dividends. The new rule would put an end to this practice. It mandates that the unit premium reserve can not be used for distributing dividends.
Many investors into equity-linked tax savings schemes (ELSS) are known to go for schemes that declare hefty dividends?as they are tax-free, and investors gets some part of the money back immediately. Say, for instance, you invest a lakh of rupees into the fund and the record date is just a few days away. Higher dividend payout ratios (dividend in Rs divided by NAV as on record date) mean that you get a bigger part of your investment back instantly. A 20% dividend payout in this case is equivalent to Rs 20,000 coming back as dividend, a few days from investing a lakh into it. The investor is happy he got some money back instantly while fund houses merrily charge management fees on these assets.
What the new Sebi rule has done is left little legroom to indulge in such unfair practices. Such practices are more rampant in equity-oriented schemes that debt fuel a section of the market participants. In the past decade, the noose has been tightened by Sebi to prevent various types of malpractice. Not so long back, dividend stripping was rampant and Sebi through its rules ensured investors stayed at least for six months. Punters saw too much of a market risk in doing dividend stripping and ejected away.
Another interesting mutual fund regulation that is good news for mutual fund investors and has been introduced through the recent Sebi press release is that of reducing the maximum period of an NFO to 15 days as compared to 30 days for open-ended schemes and 45 days for close-ended schemes. Throwing the ASBA advantage is a welcome change. A mutual fund CEO says that the shortened NFO period shouldn?t be a hitch for them since the marketing campaign could precede the opening of the NFO. With a shortened NFO period, the advantage is also that investors will have their money invested faster. Previously, it seems that fund managers were investing into scrips/debt papers as and when the NFO collections were made. So if on Day 1, the fund manager got some money, the fund manager bought some scrips. On Day 2, he got more and it got invested on Day 2. The result was that the investor didn?t necessarily get the best price based on his/her time of investing. Now, Sebi has cleared that ambiguity by telling fund managers to collect all the money and invest only after the NFO closes.