When do mutual funds declare dividends

Published: January 28, 2016 at 7:18 am

Last Updated on

Have you ever wondered when and how a mutual fund declares a dividend? Or what is dividend stripping in mutual funds and shares? In this post, let us try to answer these questions with simple illustrations.

Perhaps due to the complex accounting principles involved, the standard answer to this question is, “when it has a distributable surplus”.

What does distributable surplus mean though? I started digging into this when Mr. K K Rao wanted a detailed explanation as to why there is a difference in dividends declared by direct mutual funds and regular mutual funds.

To answer this, one will have to learn mutual fund accounting rules. When I could not find a good enough resource online, I wrote to Dr. Uma Shashikant, founder, ex-CEO and current chairperson of the Cente of Investment Education and Learning.  She was kind enough to send me an unpublished concept paper on the subject. Everything that follows, including the examples, is an extract from that.

In this post, let us first discuss, when mutual funds declare dividends. In the next post, we shall take up the difference between regular plan dividends and direct plan dividends.

Let us consider a mutual fund NFO. During the NFO period, its NAV is fixed at Rs. 10 per unit. This is known as the face value per unit.

Investors buy 1000 units during the NFO period. Thus the capital that would be invested = 1000 x 10 = 10,000

Opening Unit Capital = 10,000

Current value of the portfolio = 10,000

Face Value per unit = 10

Current NAV =10

Now the fund opens for subscription’s and let us assume a few days later trades at a NAV of 12. For simplicity we shall assume no new subscriptions have occurred so far.

Opening value of the portfolio = 10,000 (unit capital)

Current value of the portfolio = 12,000

Current NAV =12

Out of this 2000, let us assume that the fund manager has sold a security (stock or bond) and made a profit of Rs. 1200

Realized Gains = 1200

Unrealized Gains = 800

NAV Composition (Rs. per unit)

Face Value = 10.0

Realised Gain = 1.2

Unrealised Gain = 0.8

Now the fund can never declare the face value as dividend! SEBI has mandated that it should also not declare unrealised gains (that is corresponding to stocks held) as dividends.

It can only declare dividends by selling its holdings, realising actual gains and then distributing them as dividends. That the realised gain of Rs. 1.2 per unit is the distributable surplus of the fund.

Therefore to declare a dividend a fund has to sell holdings and declare a dividend from that portion alone.

When units are purchased, redeemed or if fund manager books profit  or loss, the above values change considerably

If the fund receives 500 new units due to a purchase,

New Unit Capital = 10000 + (500 x 10) = 15000

500 X (Unrealised Gain NAV component) = 500 x 0.8 =400

is known as the unit premium reserve.

500 X (realised Gain NAV component) = 500 x 1.2 =600

is known as equalization reserve.

Now we have

Unit Capital = 15000 –> 10 (NAV per unit)

Equalization Reserve = 600 –>0.4  (600/1500)

Unit Premium Reserve = 400 –>0.27 (400/1500)

Realized Gain = 1200 –> 0.8 (per unit) (notice change in per unit value but not actual value)

Unrealized Gain = 800 –> 0.53 ( per unit) (notice change in per unit value but not actual value)

Total = 18000 –> 12 (curent NAV)

Distributable surplus (per unit) is now defined as

realized gain (per unit) + Equalization Reserve = 1.2

Therefore, the new investors will also receive the same dividend amount as that of the old investors (this is in the same fund – do not apply this to regular vs direct).

What is dividend stripping?

This is exploited by many AMC who ‘informally’ intimate the investor of an upcoming*  dividend via distributors. So a HNI puts in a lare amount of money in a say, an arbitrage fund and immediately receives a tax free dividend (rate being same as that of existing investors).

* investment has to be done 3 months before date of dividend (and therefore the intimation too!)

Once the dividend is declared the fund NAV will fall to the extent of the dividend.  Now when the HNI redeems  (after 9 months for mutual funds and 3 months for stocks) there will be a ‘ capital loss’ which can be used to evade tax. This is known as dividend stripping.

Manoj Nagpal, CEO of outlook Asia Capital in Mint article talks of clever accounting practices (do not understand this yet)  to enhance the distributable surplus and promote dividend stripping:  Mutual fund stripping: creating book losses of Rs8,500 crore 

This article prompted SEBI to ‘ask'(?) fund houses if they were adopting this practice.

There is a lot more ground to cover on dividends, but it is a heavy post already. We will consider the reserves mentioned above in more detail in another post.

Do let me know if you have any questions or comments.

Reference:  Concept Paper on Unit Premium Reserve and distributable surplus in a mutual fund, April 19, 2010, Uma Shashikant and Taruna Changulani, Centre for Investment Education and Learning. If you want this paper, please ask her (not me).

I would like thank to Umaji for her generosity in immediately sending the above paper for my understanding.

To be continued …. (if you are not too bored that is)

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