Wednesday, April 28, 2010

MF Dividends Disturbed

As many investors in mutual funds always do, we usually pick out mutual funds that have a track record of declaring healthy dividends every year and invest our hard earned money in them. The Stock Exchanges Board of India (SEBI) has come up with a new ruling that aims to disturb this trend which is likely to affect the amount of dividends declared my fund houses on their equity oriented schemes.

What the new rule says:

As per regulatory requirements the unit premium reserve (UPR) which is part of the sales price of units that is not attributable to realized gains and hence cannot be used to pay dividends.

Actually, this is not a new rule but rather has been part of the regulations for mutual fund houses for many years. Still, many MFs have used their UPR to declare dividends. This ruling from SEBI is aimed at curbing this practice.

Before we start discussing further we need to know what UPR is.

What is Unit Premium Reserve

When units of an open ended mutual fund are sold and the sale price is higher than the face value of the unit, part of the sale proceeds that represents unrealized gains are credited into a separate account which is called the Unit Premium Reserve.

Let us take an example:

Suppose A invested Rs. 10,000/- in a fund with NAV as Rs. 10/- he will get 1000 units. Assuming after a year the NAV goes up to Rs. 20/- and another investor B wants to invest Rs. 20,000/- he gets the same 1000 units which A has. Here Rs. 10/- is the unit capital and the remaining amount becomes a part of the unit premium reserve.

Let us say after another one year the MF house wants to declare a dividend when the NAV is at Rs. 30/- they will declare dividends based on the units held and not the amount invested which essentially means that for the person B who invested Rs. 20,000/- and bought 1000 units is going to get a dividend out of the money he invested rather than on the profit that was made out of his investment.

What this means to us (Investors)

The new regulation means that there will be no more hefty dividends on MFs. The dividends will have to be limited to the profits they make out of the investments and not from the UPR and hence they may not be as significant as the dividends declared out of the UPR.

In one line – Dividend Income is expected to come down significantly!!!

What does this rule intend on doing?

The rule intends on stopping/curbing two things:
1. Declaring dividends to investors from their own money (From the UPR)
2. Dividend Stripping.

Dividend Stripping
is a technique that is rampant in our stock markets because it is extremely legal and some investors use that to evade income tax on capital gains. Let me explain how…

Most MF houses unofficially inform investors about dividends before the actual dividend declaration date. Armed with this info, some investors invest money in the fund and pocked a tax free dividend and then exit the fund after a few days/weeks. Then they set off the losses from the investment against their other capital gains thereby reducing the tax liability on their capital gains.

With the new enforcement of the dividend rule, such investors may not be able to gain significant advantage because the dividends declared my fund houses is bound to go down.

Will Dividend funds become less attractive going forward?

The answer is “maybe” one of the main reasons people invest in dividend funds is the fact that, fund houses declare solid dividends every year. With the new ruling the dividend amount is sure to take a beating but still fund houses will declare decent dividends in order to retain their market edge. Hence I would keep myself invested in these funds and would not consider exiting just because they wont declare super dividends…

Happy Investing!!!

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