If you think buying a mutual fund’s (MF) monthly income plan (MIP) will pay you dividends every month, you are mistaken. According to rules laid by the Securities and Exchange Board of India (Sebi), MFs cannot assure dividends or principal.

But if you don’t look at MIPs as avenues to deliver regular dividends and instead treat them as investments that can fetch you higher returns than what your bank fixed deposits would give you over the long term, MIPs can work out for you. Here’s why.

The machinations

Graphics: Yogesh Kumar / Mint

MIPs try, but not promise, to pay dividends regularly, either monthly or quarterly. To ensure regular payments, it manages its debt component conservatively. The returns kicker comes from its equity investments.

Shobit Gupta, head (fixed income), Principal PNB Asset Management Co. Pvt. Ltd says: “The idea is to provide as much security as possible against interest rate volatility."

And here’s where one MIP can drastically differ from the other—in terms of returns as well as risk profile. From investing nothing in equities, MIPs invest up to 25% in equities. The more it invests in equity, the higher is its risk profile.

For instance, Birla Sun Life MIP Savings 5 invests up to 5%, Birla Sun Life MIP invests up to 15% and Birla Sun Life MIP 25 invests up to 25% in equities. Others such as HDFC MF prefer to call its conservative option (that invests up to 15% in equities) as a “short-term plan" and its aggressive option (that invests up to 25% in equities) as a “long-term plan".

Do they skip dividends?

MIPs may aim to pay regular dividends but they can’t assure you any dividends as per Sebi norms. Since they invest in equity and debt markets, just like any other MF scheme, and can’t have regular returns MIPs skip dividends regularly. Data provided by MF tracker Morningstar tells us that between 2005 and 2007, MIPs skipped dividends for two months in each year on an average.

In 2008, when equity markets crashed, two funds, Canara Robeco MIP and DSP BlackRock Saving Manager–Moderate, did not declare a single dividend throughout the year. While the former lost 11%, the latter lost 0.68% in 2008. Only two of the 38 funds in this category have not skipped a single dividend between 2005 and 2009.

Quarterly plans have a better track record as they need to distribute dividends only four times a year instead of every month. Of the 38 funds in this category, eight funds have paid dividends in every quarter between 2005 and 2009.

Do high dividends matter?

For instance, if you had invested Rs1 lakh in the growth option of HDFC Monthly Income Plan–Long Term Plan at the start of 2007, you would have earned 18.18% returns by the end of the year. But if you had opted to receive quarterly dividends instead, you would have earned 7.39% as dividends. The rest would have come by way of capital appreciation.

“Consistency of dividends is more important. It’s not necessary to declare high dividends. As far as possible, fund houses avoid skipping dividends," says Ritesh Jain, head (fixed income), Canara Robeco Asset Management Co. Ltd.

The excess dividends get accumulated and paid out during troubled times when funds fail to earn from the markets. For instance, in 2008, despite bad markets, 19 funds skipped only up to four monthly dividends.

What should you do?

Look at MIPs more as a long-term product instead of an investment that yields monthly income. If you had invested in a 5-year AAA-rated debt paper on 31 December 2004 and stayed invested in it for five years, you would have earned 6.99% at the end of 2009. MIPs returned 9.04% in the same period. “The kicker in returns came due to their equity investments. Over a long term, they can outperform traditional fixed income instruments," says Amit Trivedi, CEO, Karmayog Knowledge Academy, a Mumbai-based MF training institute.

Watch out for your MIP’s stated asset allocation in its offer document and match it with what the fund actually does. For instance, ICICI Prudential MIP’s offer document says it will invest in equities “between" nil and 15%. This means it can manage its equity portion more dynamically. In troubled times, it can sell a chunk of its equity portion and get into cash or short-term debt.

HDFC MIP–Long Term Plan’s offer document says its “normal equity allocation" will be 25%. The fund has consistently remained invested in equities between 20% and 25%. Choose your style.