Insights

Why you should not invest in equity funds for dividends

May 8, 2017 . Mutual Fund Research Desk

We have seen investors invest in a fund because the fund is expected to declare dividends. They also opt for dividend option as a means of regular cash flows. We are of the view that choosing the dividend option for these reasons is not prudent.

Before we explain why, let us recap how dividends are paid by mutual funds. A fund manager can declare dividends only from the realised profits. By this we mean that, in an equity fund, a fund manager should have either sold stocks at a profit and use such profits to declare dividends; or it may also have cash in the form of dividends received from the stocks it holds and use it to declare dividends. Similarly, in a debt fund, the interest or the coupon received in the fund can be declared as dividend or any profits booked by selling an underlying instrument can be declared as dividend.

You can read our previous article on how dividends are declared

In this article we will be looking at why it is not the most optimal of options to be investing in dividend schemes of equity funds especially when in requirement of regular cash flows.

Dividend payment by equity funds
Let us look at some numbers to understand this. Take the 285 equity funds that make up the large-cap, midcap, small cap, diversified, thematic, index and international fund categories. We took these categories as they are the often chosen ones. Then consider the past five years, a period which has seen market highs and brief corrections – a good period to judge dividend trends for equity funds.
In the last five calendar years, on an average dividends were declared 2.5 times. That means only 50% of the time in these 5 years were dividends declared. When we consider the quantum declared, only Rs 4.7 per fund on an average has been declared over the five years. This works out to less than a rupee of dividend declared per year across all the funds.

And remember while dividend at Rs 4.7 might seem like 47% on the face value of Rs 10, that would not be the price of your fund. For example the yield of a fund you bought at an NAV of Rs 200 may be just 2%. Our purpose behind quoting the quantum is to let you know that the amount given back is not high enough for you to generate meaningful income.

Let us drill down further. In 2016, only 68 equity funds declared dividends. In 2015, 150 funds had declared dividends.

This number was 143 in 2014, 103 funds in 2013 and 106 in 2012. Equity funds usually declare dividends only once a year. But even where funds declared dividends more than once, the sum of these dividends was still around the category average.

Dividend in equity funds is thus sporadic. This is so since the declaration of dividends is entirely at the discretion of the fund manager. Both the decision of when to and how much to declare is decided based on market conditions and the realised profits that a fund has.

Investing before dividend declaration
While fund houses are not supposed to announce a dividend declaration too ahead, investors who get to know about such ‘news’ invest in a fund thinking that they will make some immediate profits. The fact is that they only get back a part of their own money. This is because, dividends are only stripped from your own NAV.

For example, in the case of Franklin India Bluechip, on the record date, the NAV was 38.6139 (as on 5th Feb 2016). Once a dividend of Rs 3.5 was declared on a face value of 10, the NAV ex-dividend fell to 34.6706 on 8th Feb 2016 factoring the dividend paid.

In other words, your own money would have come back to you had you invested in just before the dividend declaration.

Given the erratic nature of dividends, the small quantum, and the fact that you do not make money by simply buying a fund before dividend declaration, dividend is not the best of options in equity funds.
Also, remember, equity funds are meant to build your wealth. That means you should allow your money to stay and grow. Once you take them out as dividends, it goes into your bank pool for spending. At best, in risky options such as sector funds, which are dependent on their sector cycles, dividend option may help take out some money when they going is good.

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7 thoughts on “Why you should not invest in equity funds for dividends

  1. I think, the first and foremost important reason for not investing in dividend fund is not disclosed by the author. The first reason is that it attracts dividend distribution tax which lowers the return in long range. One can easily calculate the difference in the returns in dividend fund and growth fund. So growth funds are the best options.

    1. Hi,
      Agreed with your point that growth options are the best options.
      But please note that equity funds do not attract dividend distribution tax upon distribution of dividends as you have mentioned. This dividend distribution tax is applicable to all non-equity funds, like debt funds, international funds with over 65% invested in overseas securities to name a few.

      There are couple of other posts on dividends options that have already been comprehensively covered and a link for which is provided as a part of the article and here is another for your reference as to when to opt for dividend option. https://blog.fundsindia.com/blog/mutual-funds/should-you-choose-the-dividend-option-or-the-growth-option-2/9676 . Hope this helps.

  2. This blog is confusing and makes little or no sense.

    How is the number of times dividend is declared in a given Equity fund ever a metric for understanding how good or bad the fund is? Or, for whether one should or shouldn’t invest? If an investor is investing in an equity fund, he/she knows there’s some risk. That’s what your website keeps saying. Dividend declarations or the lack thereof are part of that. If an investor wants predictable and periodic/regular dividends, there’s Debt funds with dividend options for that! I don’t understand why you’d run down an equity fund for not being regular with its dividend declaration!

    The growth fund basically is the same “fund” as the dividend fund except that the investor takes out the dividend. An investor who does this, in some sense, is booking periodic profits or optimizing for risk. If anything, that’s good behavior, depending on individual concerns.

    What this blog tells me is, the analysts at FundsIndia are not being thoughtful.

    1. Hi Mr Pai,
      As the title of the blog aptly reads, we are trying to drive in the point that you are not supposed to invest in an equity fund for dividends especially when in need of regular cash flows. If you had read the article thoroughly one of the statement says ” In this article we will be looking at why it is not the most optimal of options to be investing in dividend schemes of equity funds especially when in requirement of regular cash flows” And this we have substantiated with numbers saying that the dividends declared by equity funds are random and sporadic.

      Not all realise that the dividend paid from a mutual fund is their own money that is paid back to them and the NAV falls to the extent of the dividend paid and many assume that it is additional money that is paid to them. This misunderstanding about dividends in mutual funds is also one of the reasons why investors subscribe to dividend options.

      The point that we are trying to reiterate is that you invest in Equity funds for its growth and how your money compounds over longer term. By taking dividends out, the compounding effect is lost.

      You are right when you say ” An investor who does this, in some sense, is booking periodic profits or optimizing for risk. If anything, that’s good behavior, depending on individual concerns.” And this is what we have said in our previous article on How mutual funds pay dividends, “Dividend options in equity are more suitable for an investor who is very risk averse.” which is the point we are trying to drive home. And this is probably the only reason to subscribe to a dividend option in an equity fund.

      Even with respect to investing in debt funds, again dividend options are not the most optimal of options when in need of regular cash flows. Kindly do refer to when to choose dividend option
      . Here again you can infer that one should subscribe to dividend option of an equity fund only due to risk averse nature and not due to requirement of cash flows

      Not in any part of this article have we mentioned that dividend is a parameter for judging an equity fund. Here at FundsIndia we use various parameters to rate an equity fund which includes measuring the consistency of performance, its volatility, risk adjusted returns and various other parameters of the fund against its peers and benchmark over both short and long term, and DOES NOT include how often an equity fund pays dividend.

  3. Equity funds invest in shares and are best suited for long term investment horizon. They provide potential for higher growth and returns with moderate to high level of risk. Also you have to pay dividend distribution tax on dividends received.

    1. Tejas,

      You do not have to pay dividend distribution tax on dividend from equity funds. DDT applies on all funds other than equity funds.

      Thanks,
      Bhavana

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