Over the last weekend I met a friend who I hadn't met in a long time. Before we could sit down for a cup of coffee, he took out his wallet and handed me two crisp thousand-rupee notes.
I obviously was taken aback by this. Then he reminded me, on the day we were leaving the city we studied in, he had run out of money and I had lent him two thousand rupees, which he had never returned.
At that point I felt very happy. I got a feeling that I had earned two thousand rupees, when the fact of the matter was that I had just been returned my own money, without interest after nearly 5 years.
We all feel happy, when we get money, even if it's our own hard earned money. Mutual fund schemes when they declare a dividend exploit this to the hilt. Let's see how this happens.
A mutual fund scheme always declares a dividend as a percentage of its face value of Rs 10. Face value is the price at which a single unit was issued initially when the mutual fund scheme was started.
So when a mutual fund declares a dividend of 50%, what it means is that an investor gets a dividend of Rs 5 (50% of Rs 10) per unit as a dividend. After the dividend is declared the net asset value (NAV) of the mutual fund falls by the amount of the dividend declared. In simple words, the NAV is current value of the Rs 10 that was initially collected and invested.
So if a mutual fund declares a dividend of Rs 5 per unit, and the NAV of a single unit before the dividend is declared is Rs 20, then after the dividend declaration the NAV falls to Rs 15. What the investor gains as a dividend he loses from the NAV.
If he had sold the unit before the dividend was declared he would have got Rs 20 per unit. If he sells the unit now, he will get Rs 15 per unit. Rs 5 he has already pocketed as dividend. What this effectively means is that the mutual fund is returning the investor his own money.
As per present regulations, the record date has to be 5 days from the date of declaration of dividend. Record date is the date by which an investor has to have the units of the mutual fund scheme, if he wants the dividend. This regulation of the record date being 5 days from the declaration of dividend came in only in April last year.
Before this, mutual funds use to announce their dividends at least a month in advance, and use that period to get investors to invest in the scheme, on the pretext of the dividend.
Now they cannot do that officially. But unofficially most of the bigger distributors of most mutual funds know in advance when the dividend is to be declared and use that period to get investors to invest in the scheme.
Investors should understand that dividends are nothing but their own money being returned to them and investing in a mutual fund just because it is declaring a dividend simply doesn't make sense.
Some investors, who understand this, still go ahead and invest in a dividend option of a mutual fund scheme rather than the growth option. The growth option of a mutual fund scheme does not declare dividends. The argument these investors seem to make is that nobody knows where the stock market is headed to. So it's better to invest in the dividend option and keep recovering the amount that was invested. In a growth option if the stock market falls, the NAV of the mutual fund will also fall.
Let us try and understand this through an example
An investor invests in a dividend option of new mutual fund scheme. Since he is investing in a new scheme, he gets a single unit at Rs 10. For the sake of simplicity, let us assume that the investor buys two units, i.e. he invests Rs 20 (Rs 10 x 2) in the scheme.
Two years down the line, the scheme has performed really well and given 100% absolute returns. With 100% returns the NAV of a single unit is quoting at Rs 20. At this point in time, the scheme declares a dividend of 100%, i.e. Rs 10 per unit.
So the investor gets a dividend of Rs 10 per unit or Rs 20 in all, as he has 2 units. After the dividend declaration the NAV of a single unit falls to Rs 10.
But the investor, by getting a dividend of Rs 20, has managed to recover his initial investment.
But this is a very naïve argument to make. A mutual fund is not obligated to declare a dividend. It declares a dividend when it feels like. So there is no assurance that the investor will get a dividend. A better approach to those looking to at least recover their initial investment is to invest in the growth option.
Take the same example. The investor had invested in two units. When the NAV of a single unit reached Rs 20, all he needed to do was to sell one unit at that price and recover the Rs 20, he had initially invested. This is where the entire argument of investing in a dividend option to recover the money invested upfront falls flat.
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