Mutual Fund Dividend is one of the most popular mis-selling points. At the same time, Mutual Fund Dividend is USP for fund houses. It is one of the key reason for the popularity of a scheme. In many cases, the popularity of the mutual fund scheme is directly proportional to the frequency, and quantum of Mutual Fund Dividend declared. The investment advisers are not kind enough to explain the novice investor that Mutual Fund Dividend is being paid from the investment only. Mutual Fund Dividend is entirely different from Stock Dividend. Financially, the dividend declared on a stock is truly your income. The stock/equity dividend is tax free. Some investors invest only in High Dividend Yield Stocks. On the other hand, Mutual Fund Dividend declared by equity mutual fund is also tax free but it is paid from your investment. Whereas Mutual Fund Dividend declared by Non-Equity scheme is a wealth killer. The culprit is Dividend Distribution Tax. To understand the difference, It is important to know how the profit is declared by the stocks. A mutual fund is just a pool of investment in stocks.
In stock/equity investment, the stock price is de-linked to the profit of the company or cash reserves. A profit/loss may impact the stock price due to sentiments, but it appear on the balance sheet of the company. A highly profitable or cash rich companies reward shareholders with regular dividends. It’s a different story that dividend declared is adjusted in stock price. On the net basis, the investor may or may not be profitable always. The dividend declared on the stock is adjusted in the NAV of the mutual fund scheme. A mutual fund scheme is just a basket of stocks. The appreciation or depreciation of the NAV is linked only to the stock price. As such mutual fund house does not generate any profit that can be distributed or adjusted in NAV. Therefore, NAV of a mutual fund scheme is purely linked to the stock price movement. Mutual Fund Dividend is like passing on the appreciation of fund value to the investors. It is like profit booking and should not be projected as an income to the investor.
Mis-selling is quite rampant on this front. Most of the investors are not aware that Mutual Fund Dividend is not an income. I am sure that once the fact is known, the investor will prefer to opt for growth option of mutual fund scheme. In fact, AMFI should consider changing “Dividend” to some other suitable word like “Return” or “Return on Investment.” At a macro level, i will term the mutual fund dividend option as “Money Back” investment plan.
Why should you not opt for Mutual Fund Dividend?
(a) Dipping into your funds: Personally, i will prefer SWP (Systematic Withdrawal Plan) compared to dividend option. The purpose of mutual fund investment is defeated with Dividend option. Normally, the objective is to beat the inflation but Mutual Fund Dividend defeats the whole purpose. Secondly, the return on investment is variable therefore any withdrawal during bull phase is ok which is like profit booking. It is a contradiction to compounding effect as discussed in next point. Experts suggest remaining invested during bull phase. During the bear phase, it causes jitters to the investor. The returns are perceived to be relatively poor after adjusting Mutual Fund Dividend. Investors judge the performance from NAV. It’s a negative for fund house as the investor perceive scheme to be badly performing scheme. The investor is not aware that he/she is eating into the returns. As a thumb rule, an investor should exit in case of negative returns from the mutual fund.
Another reason for preferring SWP is that dividend payout is not consistent. Therefore, the investor may get higher amount when he does not need funds or lower value during the need of the hour. SWP can be very effective retirement planning. The returns in case of SWP will be higher than dividend option. An investor can plan a withdrawal without disturbing amount invested. Here the key assumption is that the returns are stable. The fact of the matter is that the returns from Debt funds are also not stable. I shared it in my post, Debt Mutual Funds – 7 Hidden Risks.
(b) Compounding Effect: According to experts, Mutual Fund Dividend option does not take an advantage of compounding effect that helps to beat the inflation. To make use of same, Growth option is most preferred.
(c) Dividend Distribution Tax: For non-equity schemes i.e. schemes with less than 65% exposure in equity, dividend option is a BIG NO. As i explained in my earlier post that DDT @ 28.33% is deducted if you opt for dividend option. Broadly debt funds, balanced funds – debt oriented, etc. are covered under DDT. I am sure none of the investors are aware of DDT. It is one of the hidden secrets of mutual fund industry.
Words of Wisdom: As the world economy is becoming more volatile so as our investment options. The concept of stable returns no longer exist. The investment risk is undergoing paradigm shift that i will discuss in next post. It is also impacting the idea of long term investment. A long term investment does not exist, and smart investors are playing on a theme of timing the entry and exit. Earlier it was true for stocks but negative returns forced investors to implement the same strategy for mutual funds. After so much research, currently i found only Arbitrage funds that can offer stable and consistent returns. I will discuss the same in my future posts.
If you are investing in mutual funds, then it is always advisable to opt for Growth option. A Mutual Fund Dividend payout option works well only in case of ELSS. The prime objective is tax saving instead of investment. An investor invests during Jan and Feb of FY. Avail tax deduction on the amount invested. The fund house declares a dividend in March. Therefore, partial investment is paid back as a dividend. In short, investor availed tax deduction on the dividend paid without actual investment.
Word of Caution: The worst case scenario is when an investor in the lower tax bracket of 10% or 20% invest in Non-Equity scheme with Dividend payout option. The DDT of 28.33% means he is paying a tax of more than his tax slab. In such cases, it is better to opt for growth option, withdraw the amount and pay STCG. Growth option is more tax friendly compared to dividend option. There are multiple permutation and combinations & each case is different. Therefore, there are NO universal rules. Always remember that the financial awareness is key for any investment. All the financial decisions should be taken only after thorough study and due diligence.
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