Dividend stripping may be an undesirable development in the mutual fund industry. But there is no denying that it has come to the rescue of fund managers on more than one occasion, particularly last week.

What is dividend stripping?
Let us take a mutual fund, which has declared 50% dividend on its growth scheme. The record date is say 2 weeks from the date of dividend declaration. Now an investor who enters that particular scheme before the record date, can avail of the 50% dividend. After accepting the dividend, the investor will witness a fall in the NAV (net asset value) of the scheme. When he exits the scheme (at the lower NAV) immediately after pocketing the dividend, he will record a short term capital loss. The capital loss will be to the extent of the difference between the NAV when he entered the scheme (before dividend declaration) and when he exits the scheme later.

The poor investor has actually suffered a capital loss. A closer look at the facts reveals that the investor is far from poor, and has actually become richer. For one, he has collected 50% dividend, which incidentally is tax-free. (On a Rs 10 unit, 50% dividend amounts to Rs 5). Moreover, the investor will be more than happy to offset capital gains (on other investments like shares) against the capital loss on his mutual fund investment.

While the investor is a lot richer, the same can't be said about the exchequer, which has lost the opportunity to collect some easy capital gains tax from the investor. And what about the mutual funds? Well, the funds are not comfortable with the volatility in inflows and outflows at the time of dividend declaration. While there is a surge in inflows just after the dividend announcement, there is an equal if not greater exodus after the record date. Funds have even tried to impose a higher exit load to discourage redemptions, but that has failed to curb outflows.

Looking at it purely from the fund manager's perspective, dividend stripping has actually bailed them out time and again. Over the past few weeks, when the markets slumped dramatically, fund managers were caught in a grip of high redemptions, in the region of Rs 25 bn. But figures released by the Securities and Exchange Board of India (SEBI) revealed that fund managers were actually buying and not selling, despite the redemption pressure. So what came to the fund manager's rescue? You guessed it  dividend stripping inflows.

Corporates and even retail investors entered funds in hordes to collect some easy tax-free dividends, and exit later with a capital loss on their investments. The huge inflows came as a big relief to fund managers, as they offset the outflows in the form of redemptions. Net, net, the fund managers did not have to worry about offloading stocks like Infosys, Zee Telefilms, Satyam Computers at rock-bottom prices. In fact they actually bought these stocks!

But what happens when dividends run dry and fund managers are facing a surge in redemptions, then there will be no cushion of dividend stripping inflows. In that case they will forced to offload stocks, maybe at cheap prices, if the market is facing a slump. Then investors who remain invested with the fund will suffer to the benefit of those who exit after collecting their dividends. Serious investors may want to note that.

So is dividend stripping a bane or a boon? Ask the fund managers!

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