Photo: Ramesh Pathania/Mint
Photo: Ramesh Pathania/Mint

Anyone in the mood for dividends?

It would be ideal if dividend plans are junked or at least investors learn that there is no need to link returns with cashflows in mutual funds

The mutual fund industry in India has got itself into a tangle on the issue of dividends many a time. Monthly income plans (MIPs) with monthly dividend frequencies have skipped their dividends, prompting the regulator to ask for a disclaimer stating that MIPs could skip monthly dividends. Unusually large dividend declarations with their tax-free nature have been used to create a capital loss that is used to set off capital gains accrued elsewhere, prompting income tax authorities to change the rules for factoring such a loss and ensuring the regulator comes in with a defined process for dividend declarations. The latest discussion has centred on declaration of monthly dividends in equity-oriented funds and their sustainability.

Mutual funds have been marketing monthly dividend schemes in such a way that investors may assume that the dividends will continue and they can depend on those to meet their monthly requirements.

What does dividend actually mean and what is its purpose? says that dividend is a pro-rata share in an amount to be distributed; a sum of money paid to shareholders of a corporation out of earnings. The last part about paying from earnings is important. It’s worth noting that despite mutual funds being in existence for the most part of corporations’ existence, there is no definition of what dividend means as applied to mutual funds.

Mutual funds are not corporations to have any earnings of their own; they are basically portfolios of corporations which generate “returns", not “earnings". Further, corporations rarely find themselves in a position to return capital or meet cashflow requirements of investors, whereas mutual funds can provide liquidity to their investors almost at call by way of resale of units.

So why such take up of dividends by mutual fund investors despite unreliability and no fundamental reason? It’s not like all investors go for dividend options; in fact around 50% of all investors and probably a larger value of assets under management (AUM) is probably in growth plans as dividends have become less tax-efficient over time. Interactions with investors tell us that there is a good base of investors who want cashflows but are unable to differentiate between terms like return on capital, return of capital, dividends and plain cashflow requirement. Dividends connote “return on capital" without a direct proportionate impact on the original capital and this is what draws investors to dividend; whereas applied to mutual funds, the concept almost entirely results in “return of capital". One can argue that mutual funds too earn dividends from underlying companies but a simple calculation of dividend yield on some of these portfolios will tell you the argument is bogus. Corporations usually declare dividends after audited profits for a review period are announced and the management, after factoring capital related decisions, recommends a payout to the board. Dividend declarations from mutual funds are indeed “return of capital" as gains generated by mutual funds are only from the sale of securities and there is no correlation between the act of declaring dividends and trading operations of funds. 

A portion of investors has capital that they can invest, but it is from this capital that they need to sustain themselves, which requires predictable cashflow. Yet another set of investors does not want cashflow for sustenance but sees regular cashflow as frequent “profit-booking" from a variable return asset or they see cashflow from an investment as proof of its reliability and goodness. The fact that some funds pay dividends every month is creating wrong perception. Investors are led to believe that because it is called dividend it must be a “return on capital" and because it comes every month, they can use it for sustenance or for regular profit booking. There is a pressing need to be able to distinguish “cashflow" from “return on capital".

It would be ideal if dividend plans are junked or at least investors learn that there is no need to link returns with cashflows in mutual funds. Over the long range, if your return expectation from, say, large-cap equity funds is 12% compounded annual growth rate (CAGR) or 9-10% from a hybrid mix of debt and equity, you can just set a standing instruction with the fund house to pay you 0.75% of your capital per month or 0.6%, respectively, as withdrawal.

A 12% CAGR, return expectation will play out probably as an average of negatives combined with positives. As long as your annual withdrawal rate is well below the expected return and you judiciously calibrate the process where needed, your capital remains intact over time. There is also potential for a pleasant surprise at the end of the desired tenure if the fund outperforms the asset class or the asset class beats expectations. Moreover, even the tax differential between so-called dividend plans and growth plans is nearly neutralised.

And for the fund industry, setting right expectations and educating investors will have a better outcome than taking the short cut of pandering to emotional interpretations of words. 

Aashish P. Somaiyaa is managing director, Motilal Oswal Asset Management Co. Ltd