Is Dividends from Mutual Funds a Boon or Bane?

A mutual fund scheme can declare dividends only from the realised profits in its portfolio. Realised profits are the gains made by the fund manager from instruments by selling them and booking profits or when he receives dividend or interest (in the case of debt funds) from the instruments the scheme holds.

Dividend schemes can announce dividend daily, monthly, quarterly or annually as the case may be. For example, many hybrid funds or monthly income plans endeavour to give a monthly dividend to their unit holders.

For example, if you have invested in a fund at the NAV of Rs 15 and opted for dividend option. The scheme performs and after appreciation, the NAV reaches Rs 18. The fund house may decide to pay out Rs 3 as a dividend. So you receive Rs 3 and simultaneously the NAV will fall back to Rs 15. If you invest it back your NAV will go back to Rs 18.

What can you do With Dividends?

Unrealised profits or paper profit from the instruments held cannot be used to pay dividends. These profits are added to the NAV. Some part of this can be declared as dividend depending on the fund manager.

Alternatively, the fund manager could also deploy this money back in buying stocks or debt instruments in line with the scheme objectives.

When is Dividend a Boon?

Lower Risk: Financial planners recommend dividend option for conservative investors in equity for those who are risk averse and those who need some cash flows.

Regular Cash Inflow: Another case when it is useful to collect regular dividends is where you need income to meet your expenses and dividends can be a good way to achieve the same.

Tax Benefit: Dividends received from all mutual funds are tax-free in the hands of the investors. However, in the case of debt funds, the fund house pays a dividend distribution tax of 28.84% which includes surcharge and cess. In an equity mutual fund, there is no dividend distribution tax.

When is Dividend a Bane?

Reduces Investible Fund: Every time it pays out a dividend, the mutual fund reduces its own investible funds. Either it uses the cash available with it or it sells some of the investments to generate that cash and pay the dividend to you.

Eliminates Compounding Effect: As soon as the money arrives in the bank, it is out of work. It is highly possible that you will spend it. The same money, if it had stayed invested, could benefit from the power of compounding leading to a growth in the final investment corpus. As an investor, while you may feel you have gained (dividend), you are actually at the losing end.

To sum it up

Many investors opt for the dividend option in a mutual fund scheme, as it gives them intermittent cash flows, which comes handy in meeting their regular expenses.

However, when it is not required it is best to reinvest the dividend back into the fund. This is because the compounding benefit is lost when the dividend is paid unless the amount is invested immediately in a higher than equity yielding asset.