Should You Opt For Dividend Option Offered By Equity Funds Now   Feb 07, 2018


Tax-cut

Though the event of this year’s Union Budget 2018 is over, its adverse impact is still being felt on Dalal Street. Thanks to the 10% tax on Long Term Capital Gains (LTCG) arising out of sale of equity investments and 10% Dividend Distribution Tax (DDT) on dividend declared by equity-oriented mutual fund schemes  ––both of which have been a double-whammy.

The DDT on equity mutual funds brings dividend and growth plans of mutual funds on par with each other.

Until now, the dividends paid under equity schemes——those investing more than 65% of their assets in equity shares and other related instruments——were tax-free.

What are the potential effects of this move on the market?

  • Many mutual fund investors invest in dividend options of equity schemes to earn regular income. So far, they had paid no tax on such income, but with the mutual fund houses having to pay DDT, the dividend income will fall and certainly become less lucrative to investors.
     
  • Over the last one year, fixed deposits became unattractive to investors due to the falling interest rates. However, now interest rates are moving up. Recently, the SBI raised its interest rates on bulk deposits in the range of 50 basis points to 140 basis points. A basis point is 100th of a per cent. Other banks may follow suit. Given that, and not ruling out the possibility of RBI increasing policy rates going forward (since inflation is moving up), investors may once again approach fixed deposit as an investment avenue.
     
  • The government increased the exemption limit for interest income of senior citizens earned on deposits kept with banks and post offices from Rs 10,000 to Rs 50,000.As a result, equity-oriented schemes may not appeal to investors above 60, particularly to those with not a very high income.
     
  • Last year, mutual funds had mobilised more than Rs 1 lakh crore from domestic investors. It seems, the proposal to tax LTCG as well as DDT on equity-oriented schemes may hamper the inflows into equity schemes.

What the industry experts feel?

Mr Deepak Parekh, the Chairman of HDFC Asset Management Company (AMC) said, "Sentiments may get impacted as mutual funds have been gaining traction among investors as route to invest in stock markets."

Mr Jimmy Patel CEO of Quantum Mutual Fund said, "Fund houses have to realign the distribution strategy, dividend stripping may get controlled while for the investors may end up paying tax even in the short term."

More likely, dividend options may become redundant, going forward.

Here are some common myths investors have about the dividend option in mutual funds, which PersonalFN has attempted to debunk:

Myth #1: Frequent dividend declaration is an indicator of fund’s performance

Often the dividend that a mutual fund declares is co-related to the dividend earned on the equity portfolio. But unlike the dividends earned through investment in equity shares, where the company distributes its profits earned with shareholders; in case of mutual funds, it is a function of the market movement (usually upward) resulting in partially books profit with an impact on NAV (Net Asset Value).

For example, when the NAV of a mutual fund scheme is Rs 12 and a 20% dividend is declared, i.e. Rs 2 (20% on the face value of Rs 10/-), the NAV of the fund ex-dividend falls to Rs 10 on account of dividend declared, plus it may be exposed to downside volatility. Thus, in effect, mutual fund houses are returning your money to you. 

Myth #2: Dividend options have lower NAV; translates into a buying opportunity

You may have observed that the NAV of a dividend option is lower than that of a growth option. This is because, as and when dividends are declared, the fund NAV continues to the extent of dividend payouts.

And often, many mistake this fall in NAV as a buying opportunity. They believe they will earn similar dividends or even higher, even in the future. As result, many evince interest and the size of the fund goes up. 

In the race to garner more AUM (Assets Under Management) in the past, fund houses have resorted to tactics of declaring abnormally high dividends, but in the long run investors who fell prey to this were left with empty baskets. 

Myth #3:  Dividend History, a measure to select best funds

Investors often give high emphasis to the mutual fund's dividend history, using it as measure to select mutual fund schemes for their portfolio. It is assumed that the dividend trend will continue going upward.

But what they fail to recognise are the undercurrents——the market and the portfolio——may become unfavourable and impede dividend declaration.

It is easier to declare dividends when markets are doing fine, but you should always check if the fund has performed equally well across market cycles, and if it has declared similar dividend rates during the ‘bear’ phase of the market. This will help you gauge the consistency of a mutual fund scheme fund to an extent. 

Hence, one should not consider only the dividend history in isolation. It is important to study a host of quantitative and qualitative parameters before selecting mutual funds.

Myth #4: Dividend can be regular source of income

While many a times mutual fund distributors/ agents / relationship managers promote the dividend option as against the growth option. They attempt to lure investors claiming that it could serve as a source of regular income.

But the fact is mutual fund schemes don’t guarantee regular dividends. There is no set schedule for the payment of dividends, nor are the dividend rates predictable. If fund falters as a result of the negative currents, dividends may be hindered.

Hence, you cannot depend on the dividends that the mutual fund schemes declares for regular income / cash flow.

To conclude:

When investing, prefer the growth option over dividend option; because with effect from April 1, 2018, 10% Dividend Distribution Tax (DDT) will be levied on equity-oriented mutual fund schemes.

If your goal is to grow your wealth, choosing the dividend option will end up eating away the accumulated profit at regular intervals. This will have an adverse impact on your path to wealth creation, as your profits will not be reinvested ––particularly in case of a dividend pay-out option.

Hence, if you are not seeking regular income, it will be best to opt for the growth option. Dividends are often touted to be a benefit as it is tax-free income; however, dividend pay-outs get in the way compounding.

Despite the new tax regime for equity mutual funds, remember, over the long-term equity as an asset class still remains attractive to counter inflation.

If your investment objective is wealth creation, want to clock an appealing real rate of returns, have a high risk appetite, have sufficient time horizon (of at least 5 years) before financial goals befall; diversified equity mutual fund schemes are an appropriate avenue for wealth creation.

Even after the imposition of 10% LTCG tax, equity mutual funds can earn you decent post-tax returns provided you take enough care to select the best mutual fund schemes, are investing for the long-term (at least 5 years) and have set your post-tax return expectations right.

Editor's note:

Are you confused with the present market conditions?

Will the market go up or down from here?

Should you invest at all? If yes, how?

Which mutual fund schemes to invest?

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