Dividend payout is different for stocks and mutual funds. In the former’s case, the company gives back the investors a part of its profit but a fund is simply returning you part of your investment.
Say someone borrows Rs 10,000 from you today and returns Rs 2,000 in a couple of days. Will that mean you earned 20 per cent on the money you borrowed? Obviously not.
Only if the borrower pays you Rs 2,000 over and above the Rs 10,000 borrowed, can you earn a return of 20 per cent on the money. Since the borrower paid back Rs 2,000, he/she is returning a part of the capital and that is not same as return on capital. The above example is fairly simple. However, when it comes to investing in mutual funds, many investors mistake a return of capital for return on capital.
The difference: When a mutual fund house pays a dividend on a scheme, it essentially part returns the capital or the invested amount and does not return on the capital. Many are not clear on this, and distributors mis-sell investment schemes to investors on wrong knowledge. This is especially true in the case of equity-linked saving schemes (ELSS), where large dividends are doled out as year end approaches and investors are lured into investing in these, based on a promise of quick return on capital.
Dividend payout on investments in mutual fund and stocks is different. But, investors think the significance is similar in both cases. If Infosys gives you a dividend, it transfers money from its profit , that is, over and above the money you've put in to buy the stock. In fact, the dividend is extra gains for you, over the gains from stock price movement. However, mutual fund houses pay money from your investments as dividend. It’s basically just your money coming back to you.
The calculation: The value of your investment or the net asset value (NAV) falls to the extent of the dividend. For instance, as on September 29, the NAV of the growth option of HDFC Equity Fund was Rs 248.56, whereas that of the dividend option was Rs 41.99.
The difference of Rs 206.57 per unit is, to a large extent, nothing but your own money given back to you (as dividend). The investor who has chosen not to receive the dividend is owed Rs 248.56 per unit by the scheme, whereas an investor choosing the dividend option is owed only Rs 41.99.
It becomes more complicated when it comes to equity-linked savings schemes (ELSS). Say the NAV of an ELSS fund is Rs 100. The Securities and Exchange Board of India (Sebi) doesn’t allow declaration of the impending dividend anytime five days prior to the record date. But, many distributors get to know about upcoming dividend payments and they, in turn, inform the investors.
Say the fund is about to pay 25 per cent as dividend or Rs 25 per unit. The offer cannot be refused - 25 per cent return from dividend (Rs 25 divided by Rs 100 per unit initially invested), plus 30 per cent return due to the tax exemption, making a total of 55 per cent return on investment. And, this is just on the basic capital invested. If the scheme performs well, there will be additional return on investment.
Let’s see why this leads to misunderstanding of the dividend payout schemes by most investors and distributors. First, as explained earlier, the 25 per cent return is not returns on capital but a part of it. As soon as you receive a dividend of Rs 25, the NAV falls to Rs 75. The 30 per cent tax deduction is spread over three years of lock-in. So, at best, it is 10 per cent per annum.
Another anomaly: The term ‘dividend’ should be dropped altogether and classify all income from mutual funds as capital gain. Sample this, when the mutual fund pays you money, it is called dividend. When you withdraw an equivalent amount from the scheme, it is called capital gain. Same amount, different terms, different tax treatment. It is being misused for vested interests at the cost of lay investors.
However, investors should avoid investing in dividend option of mutual funds. in the dividend payout you lose, on compounding returns as the dividend you receive is not re-invested either by the scheme or the investor. Unlike the dividend option, the growth option reinvests the gains over and over again and the returns are compounded, resulting in higher proceed, at the time of maturity. The dividend option works best when valuations of the market seem high. When markets are at a high, the likelihood of the fund house declaring a dividend is higher. But, the amount and frequency of dividends is never guaranteed.
On the contrary, in the growth option, profits made by the scheme are invested back into it. This results in the NAV of the scheme rising over time. When the scheme gains, the NAV rises and in case of a loss, it goes down. Those who want to create wealth or have a goal to fulfil over a longer period of time should choose the growth option. Typically, those with regular income flow are advised to invest in the growth option. Those looking for a regular income such as retirees, should pitch for the dividend option.
The writer is director, Wonderland Consultants
