Dividend-stripping in mutual funds on

Rs 1,300 crore involved in past one year.

Dividend-stripping is on in full swing. In the past one year alone, a minimum of Rs 1300 crore has entered and exited equity-oriented mutual fund schemes apparently to avail of dividend stripping.

This has happened in several leading mutual funds like the HDFC Mutual, Prudential ICICI, Principal and the Birla Sun Life and also in smaller ones like the ING Vysya. The beneficiaries of this are some large and mid-sized corporates, according to reliable sources.

A study of the dividend record for the past one year shows that certain schemes see a sharp surge in their corpus exactly three months prior to their dividend record date.

After the dividend is paid out, the corpus of these funds falls substantially, showing that the money is being deployed only to exploit tax-free dividends and utilise the capital loss arising out of the transaction.

For instance, the ING Vysya Equity Fund, which declared a dividend of 65 per cent on September 15, 2005, saw its corpus climb from Rs 2 crore to Rs 85 crore in the month of June. The corpus fell subsequently from Rs 94 crore in August-end to Rs 13 crore in September-end.

Similarly, in case of the Prudential ICICI Balanced Fund, the corpus shot up from Rs 136 crore to Rs 414 crore in December 2004, three months before it declared a 35 per cent dividend (March 24, 2005).

At the end of March, its corpus had fallen to Rs 169 crore. Market sources said that dividend stripping happened in full force last fiscal since most mutual funds had good distributable surplus after the rally. Now it is resurfacing.

When contacted, Birla Mutual CEO S V Prasad said some amount of money may be coming in to avail of the dividend pay-outs but one must understand that investors also take a market risk when they enter a fund for three months.

"We believe in having a stated dividend policy to ensure that investors are rewarded periodically," he said.

According to Sanjay Sachdev, Principal's CEO, all the increase in the corpus of the fund cannot be termed as money from dividend strippers.

"We are long-term players and do not encourage this practice though we can't stop it either," he added.

Nilesh Shah, chief investment officer, Prudential ICICI Mutual, said the fund is trying to upgrade the risk profile of investors from debt funds to balanced funds. Usually, retail investors like the idea of dividend paying funds even if they do not perform as well, he added.

Kavita Hurry, CEO, ING Vysya Mutual Fund, said, "We like to pay dividends periodically to reward investors from time to time." Added Milind Barve, CEO of the HDFC Mutual Fund: "I don't think investors are looking to take any tax benefits out of the dividends since there is a market risk involved in taking a three-month exposure."

Three years ago, the then finance minister, Yashwant Sinha, tried to plug the loophole in tax laws by mandating a nine-month lock-in period for investors stepping into dividend paying equity funds in order to avail of the associated tax benefits. However, the nine-month lock-in applied to investors who enter the fund within three months of the dividend record date.

Investors are now circumventing the rules by trying to take positions exactly three months before the record date. Usually, record dates for dividends are announced about a month in advance though now most asset management companies informally tell the distributors about their pay-outs well in advance and use it as a marketing tool. Fund distributors too confirm this.

Market experts suggest that though it may appear that investors assume a market risk for three months to strip dividends, they play it safe by hedging their position in the futures market. Since fund managers on an average outperform the markets, they end up winners in the end.

Mutual funds benefit from this as they earn management fee on a higher corpus for the three-month period for which assets remain with the firm. Besides, sometimes the fund may also be able to retain a part of that money provided the performance is good.

Dividends from mutual funds with predominant equity exposure are exempt from tax. And the capital loss emanating from sale of units after the pay-out "" the net asset value of a scheme falls after the dividend is paid out "" is allowed to be set off against capital gains which lower the tax incidence.