Investing in stocks can be an excellent way to create wealth over time. Dividends represent a part of a company’s profit which the company wishes to pass on to the investors in the form of dividend income. Depending on the profits of the companies it may be declared on an annual, semi-annual or even a quarterly basis. Generally, regular declarations of dividends correlate to the company’s robust financial growth. If a company decides to limit the amount of money required for its growth and decides to give high dividend payouts to investors at regular intervals, it usually means the company does not need to spend much on future expansion and its operations are usually sustainable and stable. Only large, well-established companies can afford to do so.

While mutual fund houses invest in large companies, receive dividends and are legally obligated to pass it on to the investors, dividends in mutual funds differ mainly due to the nature of mutual funds itself. The set of rules applied for stock dividend investing may not be appropriate for the same in mutual funds. Here’s how

Dividends affect the NAV of the fund

Net Asset Value (NAV) is the full value of a unit in a particular Mutual Fund scheme. It is calculated by dividing the net assets of the scheme by the number of units outstanding on the valuation date. Since mutual funds are linked to the markets, the value of a unit changes daily. If the value of a unit is higher than that when you bought it, it means you have made a profit. Hence when the fund decides to distribute dividends among investors who have opted for dividend option, the NAV of the scheme, pursuant to pay out would fall to the extent of payout and statutory levy (if applicable). The new NAV is called “ex-dividend” (Previous NAV- Dividend) NAV. However, this does not necessarily mean a loss for the investor.

Dividend reinvestment can be a better option as compared to a dividend payout

In a dividend payout option, the AMC issues dividends to the unit holders which are transferred to the holder’s bank accounts. So the gains realised by the fund is paid to the investors and the NAV of the fund falls. Under the dividend reinvestment option, when dividends are declared, no amount is transferred into the investor’s bank account. Instead, additional MF units are bought equivalent to the declared dividend amount.In this case, the investor will have more units similar to a growth plan.

The main advantage of a dividend reinvestment option is that the AMC will reinvest the dividend amount for the investor. While the investor who has opted for a dividend payout has the option of reinvesting, she/he may be tempted to spend that amount. Regardless of whether the investor has opted for a reinvestment or payout option, the performance of the fund remains the same. So unless there is a need for periodic income, dividend reinvestment is the way to go.

Dividend Yield

Investors planning to earn regular income through dividends might want to pay particular attention to dividend yields. Simply put, dividend yield = Dividend amounts for a period/ Total investment. Imagine an investor has bought mutual fund units for Rs.10,000. For a year, the fund’s dividends have totaled up to Rs.500. Hence, the investor’s dividend yield would be 5% (500/10000=0.05).

A high dividend yield indicates that the money invested has grown and the ideal goal is that an investor can live off a regular stream of revenue coming their way without needing to sell off the investment altogether. Even for folks opting for a dividend reinvestment, a higher yield can allow them to buy more units without the need to commit additional money to expand their investments.

Total Returns tells the whole story

Dividend yield is just one of the metrics used to determine total returns. Dividends can be a result of stock dividends or bond interest earned by the fund. The NAV of the fund can also increase or decrease depending on the market. When the fund manager sells units (in the form of stocks or bonds), the profits are passed onto the investor which are capital gains distribution. All these parameters are factored in while calculating the total return from a mutual fund, thereby making it quite complicated.

Total returns can help identify which stocks have performed better and can be useful for an investor looking at the long-term (more than 5 years).

Dividends and tax

Perhaps the most significant consideration for an investor before investing is how they will be taxed. Dividends are taxed different or exempt altogether depending whether the investment has been in equity or debt.

For investors in equity mutual funds (65% of its portfolio should comprise of domestic equity shares), all dividends are tax-free at the hands of the investor.

Investors of debt mutual funds do not pay tax, at least not directly. As per the Union Budget of 2016, there is a dividend distribution tax (DDT) for retail investors at 28.84% which includes cess and surcharge whereas earlier the effective tax rate was 22.07%. The AMC deducts this amount from the NAV and the dividend the investor finally receives has already had the DDT component remitted. You can find more details here.

Finally, the decision to invest in a dividend option depends on the individual’s objectives and risk capacity. Investors should always choose a fund which invests in companies they understand.

Source : Moneycontrol