How dividends in mutual funds work

January 30, 2008 12:38 IST
Last Updated: January 30, 2008 18:55 IST
For a lot of investors, dividend income means a lot. This holds true for investors in mutual funds as well as stocks. Now, investing in stocks calls for a totally different skill set. With stocks, regular dividends (in combination with other key factors like revenue and profit growth, cash flows) do speak for the company's solid fundamentals. The problem arises when investors apply the 'dividend strategy' while investing in mutual funds. To compound matters, fund houses understand this mindset well enough to make a big deal while declaring dividends so as to draw investors looking (only) for dividends.

To appreciate the point about dividends being a misleading indicator, it's important to understand how mutual funds offer a return. Mutual funds give a return by way of appreciation in the net asset value. Being market-linked, its NAV fluctuates on a daily basis; when at any point its NAV is higher than the level at which it was bought the investor has made a profit (generated a return) on his mutual fund investment.

In reality, this is the only way in which mutual funds give a return i.e. NAV appreciation. How about the dividends, doesn't that also count as a return? Not really, because the dividend can be declared only if there is an NAV appreciation.

Confused with all this? An illustration should do the trick for you. Observe what happens to the NAV of a mutual fund after it declares a dividend.

From one hand to another

Cum-dividend NAV (Rs)	15.0
Dividend (%)	20.0
Dividend (Rs)	2.0
Ex-dividend NAV (Rs)	13.0

Notice in the illustration that the cum-dividend NAV is Rs 15.0 (this is the NAV before the dividend declaration). The mutual fund declares a 20 per cent dividend. It is obvious from the illustration that the mutual fund does not declare this dividend from its own pocket; it is drawn from the NAV. So an investor who invests in the fund anticipating a dividend declaration should consider this point before hitting the invest button. After all the money for the dividend will only be deducted from his NAV; he will be richer by Rs 2 per unit (going by our illustration), and poorer by the same amount (since the ex-NAV will also fall by Rs 2). At the end of the day, the dividend-seeking investor has no doubt pocketed the dividend, only to see an erosion in his capital by a similar margin.

In our view, investing in a mutual fund for the sole purpose of pocketing easy money (by way of dividend) can be a recipe for a disaster. This is no way to invest in a mutual fund.

How not to invest in a mutual fund

There are certain points about dividends that investors must appreciate before diving into a mutual fund for the dividend lure:

1) Dividends on mutual funds are not assured. Even if a dividend looks certain in the immediate future, there is no saying whether the mutual fund will be in a position to declare another one at the same frequency and for the same amount. As explained earlier, dividends are ultimately a result of performance, there can be a dividend only if the mutual fund has performed well enough.

2) Declaring a dividend by a mutual fund cannot always be interpreted as a healthy sign. It could mean that the fund manager just does not have enough investment opportunities and would rather return the money to investors. Or worse, the fund manager probably sold some of his best stocks to generate cash for the dividends. Either ways, the dividend spells bad news for investors. We are not saying this is the case all time, but investors must divorce mutual funds from stocks as far as dividends are concerned. With stocks a dividend could underline a strong balance sheet but it does not mean the same thing for a mutual fund.

3) When you withdraw money from a mutual fund investment by way of dividend, you lose out on the benefits of compounding. For compounding to work effectively, it's important that you stay invested i.e. preserve your original investment and if possible add to it, but do not withdraw from it, unless it's an emergency.

4) On hindsight, one scenario where pursuing a 'dividend strategy' could prove intelligent is during depressed market conditions. Investors who have collected dividends during a rally in stock markets will have something to show for during a prolonged depression, while investors who had relied only on capital appreciation will wish they had redeemed a portion of their investments during the rally. Mutual fund categories like thematic and sector funds that witness more cycles (than diversified equity funds) are apt candidates for the dividend option.

While dividends may be important for a category of investors, investing in mutual funds only for the dividends is perilous. It is more important that investors focus on the mutual fund's performance, which is dictated mainly by the fund management processes and investment style of the mutual fund. A strong performance could lead to dividends in the future, but the opposite is not true.

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