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A zero sum game

Author: Sunil Kumar Singh /Sunday, June 1, 2014/Categories: Mutual Funds

A zero sum game

Are you among those retail investors who feel tempted and buy an equity mutual fund just before it is about to declare dividends? Recently, a lot of mutual funds have declared dividends under the dividend options of their schemes. HDFC Mutual Fund for instance, declared dividend under HDFC Balanced Fund, HDFC Prudence Fund and HDFC Mid Cap Opportunities Fund. DSP BlackRock Mutual Fund declared dividend under DSP BlackRock Top 100 Equity Fund. So is Kotak Mutual Fund that declared dividend under the dividend option of Kotak Midcap. Another example is of Morgan Stanley Mutual Fund that declared dividend under Morgan Stanley A.C.E Fund.
The temptation is not for naught. Buying a fund before it pays dividends appears to be a smart strategy to many. After all, as they believe, dividend is the ‘extra’ income and that too is tax free! But is it really that tempting?
There are many issues you need to consider before making an investment decision.
Mutual fund schemes are broadly of three types — dividend, dividend reinvestment and growth. As the name suggests, dividend options declare regular dividends while growth option doesn’t. But from an investment perspective, that doesn’t mean that dividend paying funds are more yielding than growth funds. The tax implications of the gains however could differ.  

No Value For This
It’s important to understand that a fund declares dividend on the face value (which in most cases is Rs 10) and not on its NAV (Net Asset Value). Secondly, dividends bring down the NAV of the mutual fund to the extent of the dividend payout. For example, if a fund’s NAV is Rs 11 (cum-dividend) and it pays out rupee 1 as dividend, its ex-dividend NAV will be Rs 10. If the fund didn’t pay the dividend, its NAV would have been higher and, as a result, the fund value would have been greater.
As Rakesh Goyal, Senior Vice President, Bonanza Portfolio, says, “The dividends are paid out by the fund from the profits booked and the resultant cash positions created. So if the investor invests before the ex-dividend and the fund pays out the dividend, it’s just the same as redeeming your money partially (through dividends) without any expenses and taxation (only in case of equity funds).”
To put it differently, you get back your own capital back in the form of dividend. This means, from a returns point of view, there is no difference in buying a fund cum- or ex-dividend. So if you’re looking to invest in a fund, don’t make dividend as the main criteria for investing in it.   
Usually, dividend paid is equal to dividend declared by the fund house. However, in case of debt funds, the case is different. 
“As the dividends in all debt oriented funds carry dividend distribution tax (DDT), dividend is paid after deducting DDT. Thus, in such cases dividend paid is lower than the dividend declared,” says Raajeev Chawla, Certified Financial Planner, Fundmitra.com.

Tax Benefits
The biggest, and by large the only, advantage of buying a fund just before it goes ex-dividend is the set-off benefits on the short-term capital loss. Since dividends bring down the NAV to the extent of the payout, by buying a mutual fund when it is cum-dividend and selling it when it becomes ex-dividend, you make a short-term capital loss. This short-term capital loss can be set-off against short or long-term capital gains or can be carried forward for up to eight years.
“For income tax purposes, this results in an income that is tax-free in the hands of the investor as dividends are tax free and the investor can avail short term capital loss (as the ex-dividend NAV will be lower than the cum-dividend NAV at which the investor made his investment) to be set-off against a corresponding capital gain or to be carried forward up to eight years. This is known as dividend stripping,” says Chawla.
Dividend stripping is basically about buying a stock or a unit of a mutual fund, which is likely to declare a dividend shortly. The investor, just after pocketing the dividend, sells the stock or the fund whose value automatically goes down ex-dividend. This results in him incurring a short-term capital loss that he can set-off against capital gains — both short-term and long-term. 
For instance, if an investor buys a mutual fund scheme at Rs 105 per unit, and that the AMC declares a dividend of Rs 3 and the fund’s NAV, post dividend, falls to Rs 102 per unit. The investor, in such a case, gets twin benefits. Firstly, he gets a tax-free dividend of Rs 3 and at the same time he incurs a short term capital loss of Rs 3, which he can set-off against other capital gains.
However, certain pre-conditions have been added by the income tax department for investors to get set-off benefits. As per tax provisions, if an investor buys fund units within 3 months prior to the record date for a dividend, or sells those units within 9 months after the record date, dividend stripping is not allowed by the income tax laws. This means any capital loss from the transaction would not be allowed to be set off against other capital gains of the investor, up to the value of the dividend income exempted. 
So to put it differently, mutual fund investors either have to buy units 3 months prior to the record date for a dividend, or sell those units after 9 months after the record date for dividend stripping not to apply.
Experts say that investors looking to buy mutual funds should look at the fund’s fundamentals and assess their financial goals and whether the fund is likely to make gains from here on, instead of focusing on how its dividend-paying record has been.

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