Monday, February 26, 2007

How Much Dividend Did You Get??

110% dividend, SBI MAGNUM TAX SAVING FUND. Last date 02.03.2007. Invest Rs. 11000 & take back Rs. 5500 immediately.

This was the text message sent to me by a friend of mine, who has been investing in the capital markets since over a year. I called him to verify that he knew what he was talking about. As happens with most of us, we just talk to some finance agent and take his advice without proper research as to what all that finance jargon means. As a matter of fact the more industrious of us put some effort into selecting a fund house but hardly any research as to which option within the fund to take. In this post I will try to answer the most basic questions about mutual funds that I had when I was new to investing.

Dividend payout is not some extra money.

Let's say a fund has a Net Asset Value (NAV) of Rs. 100 and it declares a dividend of 25%. You as the investor get Rs. 25 for every unit of the fund that you own. But what happens to the NAV. The NAV for the fund now reduces by 25%, i.e. it becomes Rs. 75 (Rs. 100 - Rs.25). In essence you have not made any profit. Rather, the fund management capabilities of the fund manager is in question. Why do you ask?? Because there is no fixed dividend declaration date for any fund. It is upon the whim of the fund manager that a dividend is paid to you, and one of the reasons why a fund manager may do that is because s/he could not see any viable investment opportunities.

Change the whim of your fund manager into your fancy.

When the fund gives out dividend, the NAV of the fund falls but the total number of units you own remains the same. Adding up the dividend payout and the current value of your investment, i.e. (NAV x no. of units), the value of your money remains the same. Now considering the current tax scenario in India, there is no capital gains tax for income incurred after a year. So how do you leverage this?? Simple. Sell some of units that you own in the fund. While the NAV of the fund remains the same, the number of units fall down. But you have the money you got by selling part of the fund with you. So it is upon your fancy that you get money out of the fund.

Where else am I losing money??

I loose money every time I invest in a dividend paying fund. Because most of the times such a fund will make a big effort through advertisements to preen about the amount of dividend that is being paid. And such extra costs will be added to the fund management costs, which eventually will lower the earnings. While in the growth option, at least such extraneous costs will be saved.

Any other avenues where it can be saved??

Yes. The full scenario is big and out of scope of this blog. But something that can be understood easily is this. When a fund pays out dividend, it is most likely to lie in my bank account for some period of time before I can re-invest it again. During such period not only I loose the earnings that might have incurred, I also need to pay the entry load, which in the current market scenario is anywhere between 2.25% - 2.5%. I think the picture is clear.

Surprises galore!!!

Ok. So two fund houses come out with competing NFO's (New Fund Offering) with approximately the same investment objective. So what's the deciding criteria for selection?? The NAV!!! Wrong. From a biased perspective, it would be the size of the fund house and the performance of other funds being handled by the fund manager. Why not the NAV?? Because if the fund were to buy just shares of some company say X which is currently priced at say Y rupees, then it will have to shell out the same amount of money irrespective of what its NAV is. So while the fund with lesser NAV will use a larger number of your units to buy the shares, the fund will higher NAV will use a smaller number of your units to buy the shares.

Sources (and more detailed explanations):

Don't fall for the dividend bait!
Growth or Dividend - How to make the right choice?
Demystifying NAV myths
Dividend Reinvestment v/s Growth - Let your taxes decide

As for me particularly, I wish I could save some money to actually invest. I console myself that I earn more intangible assets than tangible assets.

By the way, this post is highly biased towards investing through the growth option or at least the dividend reinvestment option. For a more convincingly biased approach, you must read the above mentioned sources. Happy investing!!!


Correction: Thanks to Gautam Satpathy for pointing out an error in the above post.

The dividend percent that is declared is on the face value of the fund unit, not on the prevailing NAV. So if the fund was issued at Rs. 10 per unit, but currently is at Rs. 80, 25% dividend would be Rs 2.5 and not Rs. 20. Correspondingly, the fund value would drop by Rs. 2.5 to Rs. 77.5 and not by Rs. 20 to Rs. 60.

There are others he has mentioned but I will get to them once I have investigated them.