FundsIndia Explains : How mutual funds pay dividends

Many investors assume that mutual funds pay their dividend from the dividends they receive in the stocks they hold. They also ask us during corporate dividend season (post annual results), why mutual funds are not paying out that dividend. But this is not the only means by which mutual funds pay you dividend – if you had opted for the dividend option. Let us understand how mutual funds pay dividend.

Where the dividend comes from
A fund can declare dividends only from the realised profits on its portfolio. When we say realised profits, the fund manager should have generated returns from instruments by selling them and booking profits or receive dividend or interest (in the case of debt funds) from the instruments he/she holds. The paper profit (unsold) from the instruments is not considered as realised profits.

Such profit is added to the NAV. These receipts may be again deployed in buying stocks or debt instruments or be declared partly as dividend.

Whose money?
The dividend that is declared by a fund is simply from the profits accrued to you from that fund. It is simply stripped from your own NAV and given to you. This is why you will see that a fund’s NAV falls when it declares dividend. In other words, you are cashing out a part of your money in the fund. This is the reason why it does not make much sense to buy funds just because they are about to declare dividends. Only a part of your own money comes back to you. You do not get any profit that is not yours.

When dividends are declared
It is entirely a fund manager’s discretion to declare dividends. Both the decision on when to declare and the quantum of dividend is the fund manager’s call. Typically, equity funds may seek to declare dividends when the market rallies a bit and the surplus cannot be deployed in too many new opportunities. Or they may declare dividend simply as an annual exercise. In down markets, you will see that the quantum of dividend, if declared, may be lower as the fund manager may have lower surplus or prefer to be buying more stocks in down markets than distributing dividends.

In the case of very short-term debt funds, like liquid funds, many have even daily/weekly dividend options as they invest in very short-term instruments which fetch them frequent interest. With respect to the monthly and quarterly dividend paying options, the distributable surplus is gradually built in the fund keeping in mind the frequency of paying the dividends.

While the monthly and quarterly options gives time for a fund manager to build a surplus this cannot be the case with respect to daily dividend option. In such cases, the fund manager has in his portfolio instruments such as REPO and CBLO that are bought at a discounted rate and sold at par the next day thus generating returns.

Having discussed how dividends are paid, we need to realise that these are not the most optimal way to building wealth; as the compounding benefit is lost every time a dividend is paid, unless the received dividend amount is invested in further higher yielding assets. Dividend options in equity are more suitable for an investor who is very risk averse.

In case of a requirement for regular cashflow from debt funds, unless you are in the 30% tax bracket, a dividend option may not be the most optimal of solutions since these dividends are subject to a dividend distribution tax (DDT) of 28.84% including surcharge and cess. You can always consider a Systematic Withdrawal Plan (SWP) if you are in the 10 and 20 per cent tax brackets.

If you hold funds for over 3 years, then dividend is a poor option as your get indexation benefits on your capital gains. In such cases, going for the growth option with systematic withdrawal will make your investment tax efficient.