Any guess what’s suddenly happened to mutual funds post Budget?

The answer: The change in the tax treatment.

As you know, starting on April 1, 2018, long term gains on equity investments will be taxed at 10%.

Similarly, mutual funds will pay a 10% dividend distribution tax on the dividends declared under equity-oriented schemes.

Over the last two years, many equity-oriented schemes have generated impressive returns and are seated on huge undistributed gains. To avoid making these gains taxable, mutual funds are distributing dividends from the accumulated profits of the schemes.

Are they doing it for the benefit of the investor?

Yes, most of them are.

But, that’s not the only motive they are working with.

Some fund houses are using dirty tricks to gather fresh Assets Under Management (AUM) under falling market conditions with the carrot-and-stick of “hefty dividends”.

Dividend payouts have increasingly become the method of mis-selling mutual funds.

What’s the trick?

Suppose, the Net Asset Value (NAV) of the fund is Rs 51 and the fund house decides to declare the dividend of Rs 8; the dividend yield comes to 15.68%.

According to Securities and Exchange Board of India (SEBI) rules, the cut-off date of holding for being eligible to receive the dividend, i.e. the record date, should be at least five days later from the date of announcement.

Since the mutual fund houses decide internally when to announce dividends, they tip off their sales force and distributors about the dividend announcement much advance, say 15-20 days. This gives the sales forces and distributors enough time to unofficially communicate this information to their investors.

The sales pitch in this case: “If you invest now, you will get over 15% returns immediately. The NAV might fall post dividend payment but you can book a loss and dodge the capital gains tax.”

This isn’t a new strategy. Mutual fund houses used it in 2007 and 2008 on a large scale. But that was mainly restricted to the Equity Linked Savings Schemes (ELSS).

At the time, their sales pitch was: “The fund house is going to pay 1000% dividend (Rs 100 on the face value of Rs 10 per unit) and the current NAV is Rs 400. This gives you a chance to claim deductions under section 80C by investing in ELSS and would help you take 1/4th of your investments off through the backdoor—by way of dividends. This saves you from blocking your money for the mandatory period of 3 years without violating any law."

The question is:

Should you invest in mutual fund schemes that are likely to pay hefty dividends in the near future?

The answer: No.

Those who rely on the dividend income earned through equity schemes would be better off if they chose Systematic Withdrawal Plan (SWP), but pay attention to the tax impact.

SWPs are gaining attention these days, and mutual fund houses offer this facility to enable withdrawals of a fixed sum of money or redeem the same number of units at predetermined intervals.

Nonetheless, to make any meaningful gain on your mutual fund investment/s, it’s important to invest in schemes that have a proven long-term record and aligned to your risk profile and needs.

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