For a lot of investors, dividend income means a lot. This holds true for investors in mutual funds as well as stocks. Now, investing in stocks calls for a totally different skill set. With stocks, regular dividends (in combination with other key factors like revenue and profit growth, cash flows) do speak for the company’s solid fundamentals. The problem arises when investors apply the ‘dividend strategy’ while investing in mutual funds. To compound matters, fund houses understand this mindset well enough to make a big deal while declaring dividends so as to draw investors looking (only) for dividends.
To appreciate the point about dividends being a misleading indicator, it’s important to understand how mutual funds offer a return. Mutual funds give a return by way of appreciation in the net asset value (NAV). Being market-linked, its NAV fluctuates on a daily basis; when at any point its NAV is higher than the level at which it was bought the investor has made a profit (generated a return) on his mutual fund investment.
In reality, this is the only way in which mutual funds give a return i.e. NAV appreciation. How about the dividends, doesn’t that also count as a return? Not really, because the dividend can be declared only if there is an NAV appreciation.
Confused with all this? An example should do the trick for you. Observe what happens to the NAV of a mutual fund after it declares a dividend.
From one hand to another
Cum-dividend NAV (Rs.) 15.0
Dividend (%) 20.0
Dividend (Rs) 2.0
Ex-dividend NAV (Rs) 13.0
You can see in the table that the cum-dividend NAV is Rs. 15.0 (this is the NAV before the dividend declaration). The mutual fund declares a 20% dividend. It is obvious from the illustration that the mutual fund does not declare this dividend from its own pocket; it is drawn from the NAV. So an investor who invests in the fund anticipating a dividend declaration should consider this point before hitting the invest button. After all the money for the dividend will only be deducted from his NAV; he will be richer by Rs. 2 per unit (going by our table), and poorer by the same amount (since the ex-NAV will also fall by Rs. 2). At the end of the day, the dividend-seeking investor has no doubt pocketed the dividend, only to see an erosion in his capital by a similar margin.
In our view, investing in a mutual fund for the sole purpose of pocketing easy money (by way of dividend) can be a recipe for a disaster. This is no way to invest in a mutual fund.
