When I made my first mutual fund investment many years back, the one thing I knew even back then was that I was investing to grow my money. So the MF agent/distributor (even though he called himself an “advisor” and was an RM at a bank) told me to pick the “Growth” plan rather than the “Dividend” plan of my selected MF scheme – mainly because the former was suited for longer-term investors while the latter was more suited for people who wanted regular dividend income.
As such, for the longest time, I used to think that the dividend-plan of mutual funds invested in dividend-paying companies & passed on the stock dividends earned from these companies to investors. And then I’d wonder how it was possible for most mutual fund schemes to have a dividend plan that gives dividends? How were some paying quarterly dividends, when most Indian companies only paid annual dividends?
I was recently researching on dividend investing strategies in India – and during the course I realised that even today after so many years, there isn’t much clarity about what exactly are mutual fund dividends & how they function. Still today, many investors opt for the dividend plan thinking they will get additional income, but this is hardly the case.
This article covers everything that you need to know about mutual fund dividends.
Basics of Mutual Fund Dividends
- Every equity oriented mutual fund scheme offered to Indian investors either has a growth-plan or a dividend-plan option
- Dividend Plan: Investors receive a dividend at periodic intervals
- Growth Plan: no dividends are distributed
- Aside of this dividend distribution, there are no other differences between the 2 plans – all investors in that scheme (whether in Growth or Dividend plan) hold the same portfolio that is managed by the same fund manager in the same style
- This difference is reflected in the different NAVs of the Growth & Dividend plans of the same scheme
- The fund manager has the ultimate power to decide whether or not to give dividends, as well as the final dividend amount
- The fund manager also decides on which securities/stocks to sell in order to make this cash available
- This amount can also be taken from fund’s cash reserves, especially in years when the fund hasn’t performed that well
- It’s common for a fund to issue dividends even if it’s made losses as not doing so upsets many investors
Dividend Plans do not equate to Dividend Strategies
- Choosing to invest in the dividend plans doesn’t mean that the fund has a defined objective to invest in companies/stocks that pay good dividends (whether it’s high dividend yield or dividend payout, etc.)
- In fact, there are only 6 mutual fund schemes that have a defined objective of investing in dividend paying companies. These come under the SEBI categorisation of “Equity: Thematic – Dividend Yield” funds, and are: the Templeton India Equity Income Fund and the 5 Dividend Yield Equity Funds from Aditya Birla Sun Life, ICICI Prudential, IDBI, Principal, and UTI
- For most mutual fund schemes, identifying & investing in stocks that pay dividends is not the defined objective: the dividend plan is merely a systematic way of returning some of the invested amount back to the investor
Impact of Mutual Fund Dividends on NAV
- The frequency of dividend distribution is pre-defined & investors can select amongst the various options
- Quarterly and Annual are the most common frequencies, though many funds also have a Monthly and/or a Semi-Annual option
- Dividend plans with differing frequencies of dividend distribution have different NAVs, i.e. if a scheme has 4 dividend plans to choose from, each of those 4 plans will have their own NAV
- The day the dividend is credit to the investors’ accounts, the NAV of the particular scheme+plan is reduced by the exact amount of the dividend
- For example, if the Scheme NAV is ₹100 and the dividend declared is ₹5/unit, then on the day the dividend goes in effect, the new fund NAV becomes ₹95
Difference with Stock Dividends
- When stocks declare dividends, the market takes it as a strong sign that the company is doing well and the business is generating enough profits to not only continue/expand operations but also give some amount back to investors
- As a result, when companies declare dividends, usually the stock price doesn’t decrease by as much as the dividend amount due to this positive signal. To learn more about the signaling effects of stock dividends, check out this blogpost
- However, with mutual fund dividends, this entire signaling effect is not applicable
- Giving dividends has no secondary positive impact on fund NAV
- In fact, since not giving dividends often leaves investors annoyed, many funds give back capital even when they should be staying invested
- When stocks announce dividends, the original investment stays & the effects of compounding stay intact – any dividend earned doesn’t reduce the original investment. However, with mutual fund dividends, this compounding effect is diminished as the investor periodically reduces their invested amount
- Mutual fund dividends are pre-taxed at DDT and are tax-free in the hands of the end investor
- If your objective is to receive a periodic income from your investments, then rather than opting for the dividend plan, investors can choose the growth plan and setup systematic withdrawals of similar amounts
- Unlike paying DDT on the entire amount received as dividends, in this case the investor will only pay the appropriate capital gains tax on just the amount of gains, and not the total amount withdrawn
- Hypothetically, if a Mutual Fund invests in only 1 stock and the fund distributes the same amount in dividends to its investors, then:
- The mutual fund dividends received will be taxed at DDT as mentioned
- If the investor puts the same amount in that underlying stock, there is no DDT & any dividend income will only be taxed once the total dividend income earned crosses 10 Lakh
- Mutual fund dividends plans aren’t usually focussed on earning dividend income, unless it’s defined in the stated objective
- Instead, they are more akin to systematic withdrawal plans that enable investors to take out some money at pre-defined intervals
- If the objective is to make periodic withdrawals, the same can be achieved in a more tax-efficient manner than the Dividend plan, as discussed above
- On the other hand, if the objective is to receive a periodic income from your investments above capital appreciation, then investors should invest in stocks directly
- This can be done by screening for & investing in companies that have an established history of paying/increasing dividends, high dividend yields, etc.
- In case you find that challenging or don’t have the time to constantly research the markets and stay updated, we have created 4 different smallcases that do exactly that
Do you invest to earn dividend income? See the Dividend & Income collection, to discover smallcase that have been specifically created to provide investors with dividend income.
Are you a mutual fund investor? Check out this collection of articles written specifically to educate mutual fund investors.