A large number of mutual funds have paid substantial amounts in dividends in the last few months. At least half-a-dozen more have announced plans to pay dividends in a few days.
But does paying hefty dividends help investors' Could it be a yardstick to judge a scheme’s performance' Should one consider the dividend track record of a scheme before investing in it' Most retail investors have an impression that dividends paid by mutual funds are real gains, but they are not.
Dividend is paid out of a scheme’s assets. If retained, the amount paid out in dividend would have increased its net asset value (NAV).
Consider this. A scheme with a NAV of Rs 20 pays a dividend of 50 per cent (or Rs 5 per unit). On payment of dividend, its NAV will fall to Rs 15, assuming there’s no change in the market value of the scheme’s investments.
Then why do mutual funds pay dividends at all' “It is an efficient tax-saving tool for people who invest in stock markets regularly,” says Dhirendra Kumar of Valueresearchonline.com — a mutual fund tracker.
In the last five months, the equity market has gone up by more than 40 per cent, and investment gurus like Marc Faber say it would continue to rise for the next 12-18 months.
Thanks to the sustained rally, people have made handsome profits. Most of it is short-term capital gains — meaning profits booked on investments less than three months old.
Most retail investors do not report these profits to evade taxes, but high net worth investors, who cannot afford to hide them, use devices like ‘dividend-stripping’ to reduce tax liabilities. How does ‘dividend-stripping’ work'
You enter a fund a few days ahead of the record date — or the day on which the fund draws up the list of holders to whom dividend is distributed. On payment of dividend, you exit. Since the NAV falls after payment of dividend, you exit at a discount to the entry price.
The difference in prices at which you enter and exit the scheme could be treated as capital loss. This loss could be set off against other capital gains to reduce tax liabilities, while the dividend, which is tax-free, compensates for the loss on sale of units.
There’s a catch, however. You must stay invested in the scheme for at least 90 days to claim tax relief on the capital loss — a stipulation set by the government earlier this year. This means to claim tax benefits you must expose yourself to the risk of market movements for three months. Previously one could get in on the record date and exit the next day, cutting market fluctuation risks to a day.
Kumar says: “Dividend-stripping is a handy tool, but meant only for people who invest in shares regularly. They take a call on the markets anyhow. So, they would have the appetite for the risks of investing in shares.”
Mutual funds would tip off potential clients ahead of dividend declaration so that they would enter the fund a few days ahead of the record date. It’s a practice that mutual funds have encouraged for years to shore up sales, but now say must be curbed.
Normally you’d have to pay an entry load for investing in an equity scheme, and an exit load, for debt schemes. The quantum of load — which is 2 per cent at the most — varies with duration of investment, but for big ticket ‘dividend-stripping’ funds are known to waive these fees.
To minimise risks of capital loss, you could take to debt schemes — or those that invest in fixed-income securities like government securities, treasury bills, and corporate papers.
Debt funds are relatively more stable. Unless in extraordinary situations like a change in interest rate, debt schemes do not gain or lose more than 2 per cent in a month.
But security comes at a cost. Equity schemes — or those that invest more than 50 per cent of their assets in shares — do not have to pay any tax. But those schemes that invest more in fixed-income securities than shares have to pay a distribution tax of 12.5 per cent plus a surcharge of 2.5 per cent — or 12.8 per cent in all — out of its assets.
Since appreciation in debt schemes is minuscule compared with equity schemes during bull runs, debt funds do not normally pay fat dividends. They do not offer attractive ‘dividend-stripping’ propositions either.
There were some exceptions though. Principal Income — a debt scheme that had a corpus of Rs 831 crore at the end of August — paid 40 per cent in dividend earlier this month. A few others paid 10 per cent each in the recent past, but these were exceptional cases.
Most schemes — debt, equity or balanced — offer a choice between dividend and growth plans. Under the latter, dividends are not distributed and all gains accrue to the NAV of the schemes.
Are dividend plans meant only for dividend-strippers' No. You should choose the dividend plan if you are a long-term investor and are averse to the tax burden on capital gains.
To book profits on your investments under the growth plan, you’ll have to sell the units. This would result in taxable capital gains, whereas under the dividend plan you could earn in the form of tax-free dividends.