Wow! Mutual Funds To NEVER Give "Dividends" To Investors

Henceforth, no mutual fund scheme shall declare and distribute "dividends" to its unitholders. Thankfully, this has finally been announced by SEBI.

Why thankfully? Why am I so happy by this seemingly investor-unfriendly announcement?

Well, simply because 'dividend' was the wrong word used for the "amount distributed" to the unitholders in the name of 'dividend'. As such, investors were often under the wrong impression that they were getting some "extra" money. This 'false belief' was often misused by some people to fool the investors.

SEBI has, therefore — vide it's circular SEBI/HO/IMD/DF3/CIR/P/2020/194 dated Oct 05'20 — decided that the word 'dividend' would be replaced by the term 'Income Distribution cum Capital Withdrawal (IDCW)'.

Many financial experts had been repeatedly pointing this out, so that the investors were not misled into making wrong choices in the name of 'dividend'. [Read: Growth or Dividend: Mutual fund option perfect for you?]

Let's understand this:

In mutual funds, dividends are not "something extra".

All the profits and gains of a mutual fund scheme — capital appreciation, dividend received from the companies in its portfolio, interest earnings or any other form of income — are added to the total corpus and hence reflected in its Net Asset Value (NAV = Total corpus / No. of units).

Therefore, when any mutual scheme declares a dividend, there is no separate kitty from where the same can be paid. The dividend money comes from the corpus itself. So whenever dividend is paid out, the corpus reduces to the extent of the total dividend amount. Consequently, the NAV too reduces. In other words, pre-dividend NAV = post-dividend NAV + dividend declared.

In shares, the dividend is paid out of the profits, which is separate from the share capital listed and traded on the stock exchange. So, for shares, dividend is additional income apart from the capital gains.

Important: This, in no way, makes mutual funds inferior to shares. It's just that the accounting and process of sharing profits are different. Return-wise there is simply no difference at all.

So now what?

Firstly, the new nomenclature will be 'Income Distribution cum Capital Withdrawal' instead of 'Dividend'. Accordingly,
- Dividend Payout will now be renamed as Payout of Income Distribution cum Capital Withdrawal or Payout - IDCW
- Dividend Reinvestment will now be renamed as Reinvestment of Income Distribution cum Capital Withdrawal or Reinvestment - IDCW
- Dividend Transfer will now be renamed as Transfer of Income Distribution cum Capital Withdrawal or Transfer - IDCW

Secondly, the mutual fund companies will also have to disclose the break-up of the amount distributed i.e. how much is income distribution (appreciation on NAV) and how much is capital distribution (Equalization Reserve).

What exactly is this break-up of the amount distributed?

As mentioned earlier, all gains are reflected in the NAV. However, for accounting purposes and to comply with SEBI guidelines to distribute only the 'realized gains', the total corpus has various components such as Unit Capital, Dividend Equalization Reserve, etc. Therefore, part of your dividend may come from the 'increase in NAV' and part from the 'capital reserves'. 

Hence, this stipulation by SEBI to give the break-up.

This change will not have any impact on the scheme or your wealth creation/distribution. Technically speaking, except for the name change, nothing actually changes as far as the operation of the schemes or the distribution of profits/capital is concerned. So, you can simply ignore these new guidelines... unless the income tax department decides to modify the tax calculations based on how much dividend is coming from Income and how much from Capital.

All you have to note is that (a) 'dividend' in mutual funds is not something extra and (b) it should not influence your investment decision [Read: Shocking mistakes mutual fund investors often commit].

However, those interested in understanding the accounting / mathematics behind this can refer to the AMFI's FAQs on Income Distributed Under Dividend Option of Mutual Fund Schemes.

This new rule is effective from April 1, 2021.

Most Important: Practically for (almost) all cases, it's best to opt for the Growth Option. Dividend (or now IDCW) Option should be avoided. From this perspective also, these new SEBI guidelines should primarily be of academic interest only.