dividend received from MF is return ‘of’ capital and not return ‘on’ capital. An unclear understanding of this concept is being misused by distributors to shove undeserving investments down an unsuspecting investor’s throat

Let’s say I borrow Rs.10,000 from you today and promptly return Rs.2,000 back to you in a couple of days such that now I owe you Rs.8,000. Will you consider your return on investment to be 20%? Obviously not.
Now, if I was to pay you Rs.2,000 and yet continue to owe Rs.10,000, then and only then can one say the return is 20%. But since I paid back Rs.2,000 and so owed you that much lesser, it is return ‘OF’ capital and not return ‘ON’ capital. The above example is fairly straightforward. However, when it comes to investing in mutual funds, many investors mistake a return of capital to be return on capital.
A dividend received from a mutual fund is essentially return of capital and not return on capital. The difference is moot, since an unclear understanding of this concept is being misused by many distributors to shove undeserving investments down an unsuspecting investor’s throat. This is especially true in the case of Equity Linked Tax Saving (ELSS) funds where large dividends are doled out as 31st of March approaches and investors are invited to invest based on the lure of a quick return on capital.
We have dwelt upon this topic in previous articles; however, with the rise in indices, MFs will slowly start declaring dividends. So it is time that we give this concept a look over.
The problem is on account of usage of the term ‘dividend’ in relation to mutual funds. Investors mistake it to have a similar significance as the term has with respect to stocks. Now, when say Infosys gives you a dividend, it transfers money from its pocket to your pocket. To that extent, Infosys becomes poorer and you become richer. However, when a mutual fund gives you dividend, it is transferring money from your left pocket to your right pocket. Post the dividend, neither is the mutual fund poorer nor are you any richer. Its only your money coming back to you. In other words, the value of your investment (NAV) falls to the extent of the dividend.
In terms of an example, as on 7th November the NAV of the growth option of HDFC Top 200 Fund was Rs. 223.82 whereas that of the dividend option was Rs. 39.91. The difference of Rs. 183.91 per unit is to a large extent nothing but your own money paid back to you (by calling it dividend). The investor who has chosen not to receive the dividend is owed Rs. 223.82 per unit by the scheme whereas an investor choosing the dividend option is owed only Rs. 39.91. Now can you find similarities between the example that we started out with and this one?
The pitch becomes even more bizarre when it comes to ELSS funds. Let’s say the NAV of an ELSS fund is Rs. 100. It whispers to the distributor (SEBI doesn’t allow declaration of the impending dividend, hence the whisper) who in turn whispers to the investors that the scheme is set to announce a dividend of say 250% or Rs. 25 per unit. The offer is one that cannot be refused — 25% return from dividend (Rs. 25 divided by Rs. 100 per unit initially invested) plus 30% return due to the tax saving making a total of 55% return on investment!! And this is just on the basic capital invested, if the scheme performs well, it will be additional icing on the lucrative cake. Now, let’s see why this boils down to downright ludicrous. First, as explained earlier, the 25% return is not on capital but of capital. As soon as you receive the Rs. 25 as dividend, the NAV falls to Rs. 75. The 30% tax deduction is spread over three years of lock-in, so at best it is 10% per annum.
It must be said that over the years, SEBI has been doing an excellent job of regulating the mutual fund industry. Apart from having caps on expenses that can be charged by a scheme to the percentage of investments that can be made in a single stock or in any one industry to more recent changes brought about like banning loads etc. are all measures undertaken to protect investor interest. Readers may remember that mutual fund NFOs were at one time called IPOs. To enable investors differentiate betwen a mutual fund IPO as against a company IPO and prevent any mistake on the investors’ part or mis-selling on the distributors part, the term NFO for new offers from mutual funds was introduced. It is time that something similar is done in the case of mutual fund dividends.
Our suggestion is to drop the term ‘dividend’ altogether and classify all income from mutual funds as capital gain. When the MF pays you money, it is called dividend. When you yourself withdraw an equivalent amount, it is called capital gain! Same amount, different terms, different tax treatment. Not required — specially seeing the way it is being misused by vested interests at the cost of lay investors. It is hoped SEBI takes note of this.

The authors may be contacted at wonderlandconsultants@yahoo.com

A N Shanbhag

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