Let me explain this with an example: You own 100 units of a mutual fund ABC Equity. The current NAV of the the fund is Rs.14. The company declares a dividend of 40% or Rs.4 per unit.
Stage 1: Prior to declaration of Dividend
NAV prior to dividend = Rs.14
Your Fund Value = Rs.14 x 100 units = Rs.1,400
Stage 2: Dividend is paid to the unit holders.
The fund pays dividend of 40% or Rs.4 per unit
The dividend you receive = Rs.4 x 100 units = Rs.400
Stage 3: Post dividend NAV adjustments.
In mutual funds, the NAV of the fund is adjusted based on the dividend given by the fund.
New NAV post dividend = Rs.14(Old NAV) - Rs.4 (Dividend Paid) = Rs.10 (New NAV)
Your Fund Value post dividend = Rs.10 x 100 units = Rs.1,000
Prior to dividend you had Rs.1,400 invested. Post dividend you have Rs.1,000 invested and Rs.400 in your bank account. In short dividends in mutual funds is equivalent to selling a portion of your investment and returning it back to you.
When does it make sense to opt for dividend payout?
- ELSS (Tax Saving Schemes): All your investments in ELSS are locked for 3 years. By opting for dividend payout, you are receiving a certian amount of your investment prior to 3 years.
- Debt Mutual Funds (Short-Term): Debt funds pay a dividend distribution tax of 12.5%. Short term capital gains from debt funds are added to your taxable income. So a short term investor who falls in the 30% tax slab can save tax by investing in a debt fund with dividend payout option. Indirectly you are paying a 12.5% dividend distribution tax rather than 30% tax on your shortterm capital gains.
- Mutual Funds which offer free Insurance (FIP): You loose your insurance cover when you make partial withdrawals in FIPs. By opting for dividend payout, you are liquidating a portion of your investment and at the same time your insurance cover continues.
- Profit Booking: If one wishes to book profits at intervals.(This can actually be handled by investor himself by selling a portion of his investments)
- Asset Allocation: Some funds offer you the flexibility to sweep dividends into another scheme of the same fund house. This facility can be used for moving the dividends declared from equity to debt schemes. On the long run this helps adust your equity/debt ratio in turn minimizing your risk.
Disadvantages of Dividend Payout?
One invests in mutual funds for creating wealth over time. By receiving dividends, you are actually liquidating your investments. Hence you are losing out on the earning potential of the amount liquidated (unless you reinvest this amount somewhere).