Published in The Hindu - Sunday Magazine on Aug 02, 2009
A bumper dividend announcement by a mutual fund scheme does not per-se merit investment.
The two popular options when it comes to mutual fund investments are: dividend and growth. As you may all know - mutual funds simply use your money to buy stocks, bonds or other investments. The value of investments and cash surplus held in a mutual fund scheme is reflected in its NAV. Time to time fund schemes get dividends or interest payments from these investments. They also make profits on selling some of these investments. Over time, these provide cash inflow for the mutual fund that it can either choose to re-invest by making fresh investments (growth option) or payout as dividend to unit holders (dividend option).
An Illustrative
Now lets take a look at the impact of a dividend or its absence, on the price - meaning NAV (net asset value) of the fund scheme. Lets say, six months back, a new Equity mutual fund scheme was launched and collected money from investors at Rs 10 NAV under two options – dividend & growth. Today, the NAV of both the growth option & dividend option is Rs 15. Due to exceptional performance, the dividend variant of the scheme has decided to book some profits in its investments and share the same with its unit holders. So it’s announced a 25% dividend. i.e. Rs 2.5 per unit.
Now Mr. Ramesh, a mutual fund investor, gets a call from a fund distributor who updates him on this “exciting” news on the very last day for dividend eligibility. Mr. Ramesh, tempted by the idea of reaping quick gains, invests in the dividend option of the scheme paying Rs 15 NAV – hoping he would earn Rs 2.5/ Rs 15 i.e 16% returns. Is he right in expecting this? Unfortunately, no. The next day (the day after the record date), assuming the market remains at the exact same level and all share prices remain unchanged, Mr. Ramesh would be shocked to see the NAV of his investment drop to Rs 12.5. Why?
This is because a dividend from a mutual fund is nothing but a return of capital held by the fund scheme. The Rs 15 NAV of the scheme with the dividend option already included the distributable cash of Rs 2.5, on distribution of which, as logic would suggest, the NAV reduced by an equal amount. There is no free lunch really! The NAV of the scheme with the growth option would remain at Rs 15 – because the scheme didn’t distribute a dividend. Mr. Ramesh is no better off choosing the dividend option instead of the growth option. And, his purchase decision triggered purely by the lure of quick returns through the dividend is a misinformed one.
Every time a fund scheme announces a dividend, the same scenario will repeat. i.e. the NAV of the scheme will drop by an amount equal to the dividend amount. Within the same scheme, the NAV of the growth option will always be higher than that of the dividend option because - money is going back into the scheme and not given to investors. For example, if you were to look at the NAV of HDFC Top 200 equity scheme as on Jul 17, 2009 - it is Rs 148.4 for the growth option and Rs 38.3 for the dividend option. The reason for the difference in NAV between these two identically managed plans is that one keeps stripping money and dispatching it to investors while the other just re-invests any gains (income). It is this re-investment that has accumulated and appreciated over time, resulting in a much higher NAV today – a substantial capital gain.
So, is there any difference at all to the investor whether he invests in the growth option or dividend option within the same mutual fund scheme? Yes, their tax treatment.
Tax treatment of capital gains and dividend
The enclosed table illustrates the tax implications of dividends compared to capital gains. If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends. On the other hand if your holding period is less than a year, then dividends attract less tax than capital gains.
An Illustrative
Now lets take a look at the impact of a dividend or its absence, on the price - meaning NAV (net asset value) of the fund scheme. Lets say, six months back, a new Equity mutual fund scheme was launched and collected money from investors at Rs 10 NAV under two options – dividend & growth. Today, the NAV of both the growth option & dividend option is Rs 15. Due to exceptional performance, the dividend variant of the scheme has decided to book some profits in its investments and share the same with its unit holders. So it’s announced a 25% dividend. i.e. Rs 2.5 per unit.
Now Mr. Ramesh, a mutual fund investor, gets a call from a fund distributor who updates him on this “exciting” news on the very last day for dividend eligibility. Mr. Ramesh, tempted by the idea of reaping quick gains, invests in the dividend option of the scheme paying Rs 15 NAV – hoping he would earn Rs 2.5/ Rs 15 i.e 16% returns. Is he right in expecting this? Unfortunately, no. The next day (the day after the record date), assuming the market remains at the exact same level and all share prices remain unchanged, Mr. Ramesh would be shocked to see the NAV of his investment drop to Rs 12.5. Why?
This is because a dividend from a mutual fund is nothing but a return of capital held by the fund scheme. The Rs 15 NAV of the scheme with the dividend option already included the distributable cash of Rs 2.5, on distribution of which, as logic would suggest, the NAV reduced by an equal amount. There is no free lunch really! The NAV of the scheme with the growth option would remain at Rs 15 – because the scheme didn’t distribute a dividend. Mr. Ramesh is no better off choosing the dividend option instead of the growth option. And, his purchase decision triggered purely by the lure of quick returns through the dividend is a misinformed one.
Every time a fund scheme announces a dividend, the same scenario will repeat. i.e. the NAV of the scheme will drop by an amount equal to the dividend amount. Within the same scheme, the NAV of the growth option will always be higher than that of the dividend option because - money is going back into the scheme and not given to investors. For example, if you were to look at the NAV of HDFC Top 200 equity scheme as on Jul 17, 2009 - it is Rs 148.4 for the growth option and Rs 38.3 for the dividend option. The reason for the difference in NAV between these two identically managed plans is that one keeps stripping money and dispatching it to investors while the other just re-invests any gains (income). It is this re-investment that has accumulated and appreciated over time, resulting in a much higher NAV today – a substantial capital gain.
So, is there any difference at all to the investor whether he invests in the growth option or dividend option within the same mutual fund scheme? Yes, their tax treatment.
Tax treatment of capital gains and dividend
The enclosed table illustrates the tax implications of dividends compared to capital gains. If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends. On the other hand if your holding period is less than a year, then dividends attract less tax than capital gains.
For long-term investors
Taking a long-term perspective, investors who need income can choose the dividend option – although this option neither guarantees the amount of dividend nor the frequency. Past dividends are in no way an indicator of future dividends, but a track record of consistency is favourable. The dividend amount should not be the sole deciding factor while investing, because technically a fund can declare high dividends by merely selling its assets – irrespective of whether it has made a profit or loss! So dividends need to be evaluated in conjunction with the total returns that the fund has been able to generate.
Investors who only need long-term capital gain (wealth appreciation preferred over income) can choose the growth option. Such investors can still pay themselves a dividend when they want liquidity or when they feel the market is overvalued, by simply selling the requisite number of units!
Taking a long-term perspective, investors who need income can choose the dividend option – although this option neither guarantees the amount of dividend nor the frequency. Past dividends are in no way an indicator of future dividends, but a track record of consistency is favourable. The dividend amount should not be the sole deciding factor while investing, because technically a fund can declare high dividends by merely selling its assets – irrespective of whether it has made a profit or loss! So dividends need to be evaluated in conjunction with the total returns that the fund has been able to generate.
Investors who only need long-term capital gain (wealth appreciation preferred over income) can choose the growth option. Such investors can still pay themselves a dividend when they want liquidity or when they feel the market is overvalued, by simply selling the requisite number of units!
9 comments:
very informative and concise, like many other posts on this blog...
-Milind
@Shyam
Very nice comparision of both options .. I have a doubt here .
You mention "If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends."
Dividents are tax free in the hands of Investors , correct !! .
Are you considering the Dividend distribution tax paid by Fund and then making the comparision ?
manish
Manish - dividends are tax free in hands of investors. I am talking about dividend distribution tax- DDT (which is deducted before dividend is distributed and hence has an impact nonetheless).
As on date, DDT is "zero" for domestic equity oriented funds (and so are long term capital gains). But for debt oriented funds, fund of funds & overseas equity funds - dividend distribution tax & capital gains (short term or long term) are applicable.
Hi shyam,
I am from non-financial domain and I admire the way you explain the financial concepts succinctly.
I have a question on tax implication on
a. Dividends earned through MF or stocks
b. Interest earned in Savings bank
question is.
a. Are the dividends earned from MF/Stocks are tax free?
b. what about interest earned through simple interest and FD. How are these taxed?
best regards
-Mali
can u plz comment on the effect (if any) on the stock value of a company after it gives dividend?
-Milind
Mali-
Dividends are tax free in hands of investor (so you don't have to worry) but they are taxed at source.
For dividends from stocks, the Company pays corporate dividend tax on dividend amount. But the good news is that dividend declared is the amount you get (e.g. if the dividend is Rs 2 per share you get Rs 2 per share in your hand) , because the tax is paid out of the company's pocket.
Mutual funds pay dividend distribution tax. But this is deducted from the dividend amount itself - so you would get less than what you are supposed to. The good news here is that Equity mutual funds (with more than 65% of assets invested in domestic stocks) do not have to pay a dividend distribution tax, though other funds do. Rates vary.
Tax on interest income has to be paid by you, except if the total interest earned on all your fixed deposits in a bank is greater than Rs. 10,000 in a financial year, you are liable for TDS and the banks will deduct the income tax at source.
Anonymous - Ideally, impact of dividend on stock price should be same as impact of dividend on mutual fund NAV. But since stock prices fluctuate wildly day to day due to various reasons , external news etc...the dividend effect may not be visible.
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