Dividend option in mutual fund does not make sense

Mutual fund houses are aggressively marketing dividend pay out to increase their asset under management. You might have also come across this in last few days via SMSes or emails. Even mutual fund distributors might have contacted you to take advantage of tax free dividend declared by the fund houses. Normally dividend is declared when there is good appreciation in the NAV due to better performance by the scheme compared to bench mark. But, in practise it is misused to garner the new business which is what happening at present. Most of the people do not understand this sales pitch and are lured to invest in the fund without understanding the risk involved in the scheme. 

What exactly happens if dividend is declared can be understood by an example. Suppose “X” an equity fund scheme has NAV of Rs. 20 in growth option as well in dividend option. The scheme was launched at Face Value of Rs. 10 few years back. Suppose the Fund house today decides to declare Rs. 2 per unit as dividend in the dividend option and you opt to invest Rs. 10,000 looking at attractive 10% dividend income which most of the lay investors do without understanding the impact and implications on your investment. You will b allotted 500 units at Rs. 20 NAV on investment of Rs. 10,000. In reality what happens is NAV of the scheme under the dividend option comes down by the amount of dividend declared (in this case by Rs. 2) whereas NAV of growth remains the same. In above case after the ex-dividend NAV of Growth option in “X” fund will remain the same at Rs. 20 but NAV under  the dividend option will come down to Rs. 18 as Rs. 2 is paid back to you by way of dividend. Most of the lay investors think that they have made profit of 10% in just one week by getting Rs. 1,000 as dividend and feel happy about their investment decision but this is not true as is apparent from the above example. In effect it is you money only which is paid back to you thus is not income but your net investment in the fund come down from Rs. 10,000 to Rs. 9,000.

According to me dividend option does not make any sense in both equity and debt. Let us understand the implications for both separately. First if you want regular income periodically than equity is not the correct asset class to invest. Equity investment comes under high risk high return category. You should invest in equity after understanding the risk involved in it.  You must invest in equity only if your time horizon is long term say 5 years or more so that you get better inflation adjusted returns. So if you want to take the advantage of India’s GDP growth you should stay invested in equity for longer period of time. Dividend option reduces your investment in equity so is not advisable. If you review your portfolio periodically and rebalance your equity proportion as per your asset allocation, there is no need of dividend option in equity. It is not timing the market but time spent in the market is more important.

On the other hand, you should know that there is a dividend distribution tax in debt mutual fund schemes which reduces your overall return. The DDT is 28.325% including surcharge and education cess w.e.f. 1^st June’2013 in all debt funds. In recent budget DDT in debt funds is raised from 12.5% to 25%. I think this is a right move by FM to plug the loophole available to big investors falling in 30% tax break. So if you opt for dividend option in debt funds you already are taxed at higher bracket whether you fall in that slab or not. So even in debt fund dividend option does not make sense.

So conclusion is making a new investment in mutual fund on the basis of dividend declared is not at all a good idea. You should take informed decision before investing in mutual fund schemes. You should consult a professional if you want regular flow of income every month or periodically. Each of your investment should be made according to your future needs and goals. Investing for short tern gain without understanding the long term impact may hit you badly. SEBI must also intervene and should issue guidelines to stop fresh investment after the date of announcement of dividend till the due date of dividend so that investor’s interest is protected.

This article is published at myiris.com on18th March'2013
http://www.myiris.com/financial/storyShow.php?dir=2013/03/18/&fileR=20130318153029715