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What you should know about mutual fund dividends and NAVs
23 Dec 2015
There are some misconceptions about dividend and NAV (Net Asset Value) in mutual funds.
The below two paragraphs will explain the meaning which will help you to understand these terms while choosing mutual funds.

Clarification about Net Asset Value (NAV)
NAV is important This misconception is actively propagated by fund salesmen in order to push new funds, which start at a low NAV. Actually, all that matters is the investment management of a fund.

A fund with an NAV of Rs 10 and one with and NAV of Rs 100 will give the same returns if their portfolios are the same. You may have a higher number of units in one, and fewer in the other, but that's irrelevant. If a fund gains 20%, your Rs 10,000 invested in it is going to grow to Rs 12,000. This could be 1,000 units at an NAV of Rs 12, or 10 units at an NAV of Rs 1,200, there's no difference.

The only use of the NAV of a fund is to compare to its own past, which is how you figure out the returns of a fund. Comparing the NAV of one fund to another is not a good idea.
Clarification about Dividend
Let’s first understand how mutual funds pay dividend. Mutual funds give a return by way of appreciation in the net asset value (NAV). Being market-linked, its NAV fluctuates on a daily basis; when at any point its NAV is higher than the level at which it was bought the investor has made a profit (generated a return) on his mutual fund investment.

So the only way in which mutual funds gives a return is through NAV appreciation. How about the dividends?  the dividend can be declared only if there is an NAV appreciation.
A lot of investors think dividend returns from mutual funds are real. The problem lies with the word 'dividend'. Compared to dividends on shares, this word has a completely different meaning in mutual funds. In funds, dividends are not an additional income, but just a withdrawal from your capital. If the value of your investment in a fund is Rs 20,000 , and if the fund gives you Rs 2,000 as dividend, then post dividend, the value of your investments will be Rs 18,000. This is how dividend declaration happens in mutual funds.
Another example to understand dividend payout by mutual funds
Suppose :-

NAV (Rs)- 15.0
Dividend declared (%) -20.0
Dividend (Rs) -2.0
Ex-dividend NAV (Rs) -13.0
IN above example - Suppose a NAV of a fund is Rs 15.0 (this is the NAV before the dividend declaration). The mutual fund declares a 20 per cent dividend. It is obvious from the illustration that the mutual fund does not declare this dividend from its own pocket; it is drawn from the NAV. So After all the money for the dividend will only be deducted from his NAV; he will receive divided at Rs 2 per unit but his NAV will also fall by Rs 2. At the end of the day, the dividend-seeking investor has received the dividend but his capital also reduced by similar margin.

A mutual fund dividend just means taking some of the money that was already yours and giving it to you. Unless you need the income, there is no sense in picking the dividend option in an equity fund. In fact, even if you need the income, it is better to pick the non-dividend (growth) option and withdraw according to your own needs and schedule. As long as the investment is more than a year old, it is tax free anyway.

But if investors are looking to make use of compounded interest rates then they should choose growth option while choosing mutual funds.
If you need regular income you can opt for dividend payout option.

The difference between Growth option and Dividend option in mutual funds
In growth option the profits you make are reinvested. In other words, the profits, along with your capital, are invested in stocks or debt for more returns.

In Dividend payout a part of such profits (an amount that the fund decides to give out) is taken out from your NAV and given to you. That means, a part of the fund’s profits are given in cash. Hence, your NAV falls to the extent of dividends. This is why the NAV of growth and dividend option are not the same.

In dividend reinvestment option too, profits are taken from NAV. But instead of giving them as cash, they are allotted (reinvested) to you as units at the prevailing NAV. Hence, indirectly, by adding more units, you simply stay invested in the fund. Theoretically, the dividend reinvestment option is the same as growth option for all equity funds.
Can retail investors benefit when equity mutual funds declare large dividends?
Yes. Since dividend from mutual fund is tax free, investors holding the scheme for more than three months can sell and book short-term capital loss and the same can be offset against other short-term capital gains. And even if you have bought these schemes only after the dividend declaration, you can sell them after nine months to book short-term capital loss.

Long-term investors need to decide whether they want to invest in equity mutual funds for generating a regular income or accumulating wealth. Accordingly, they need to choose between dividend and growth options.