Always remember that any mutual fund pays dividends out of the gains it generates. The outcome of this is that the fund size reduces by the amount of money distributed. This is clearly reflected in the drop in the net asset value, NAV, of the dividend option (by the amount of dividend per unit distributed).
Let's understand this better in way through an illustration. Suppose a mutual fund collects Rs 100 crore from its investors and on this amount makes a profit of Rs 20 crore. At this stage the NAV of your unit increases from Rs 10 to Rs 12. If your mutual fund declares a dividend of Rs 2 then the value of your units will automatically come down to Rs 10 (Rs 12 less the dividend of Rs 2) on the day this takes effect. In result, the mutual fund returns your own money back to you.
In fact, we also need to understand that when a dividend is declared, a lot of new investors put their money in the mutual fund with the objective of getting the dividend. This is achievable because there is a gap between the date when a Mutual Fund scheme declares dividends and the actual date when the dividend reaches investors' bank accounts.
Some funds may do it with the sole purpose to attract more money from new investors. The justification is that dividend is a way to distribute profits generated at regular intervals, especially when markets are overheated and there are not so many good opportunities to invest.
From our experiences in dealing with a lot of individual investors and also different types of mutual funds, we have found that a majority of investors still do not have complete understanding about dividends declared by a mutual fund. The tax characteristic adds to the misunderstanding. Now let us throw some light on this issue so that it enables you to take a more knowledgeable decision.
For ease, let us limit our scope to the equity-oriented mutual funds. To meet the requirements as an equity-oriented mutual fund, the minimum holding a fund needs to have in equities is 65 per cent and above. That is if a fund collects Rs 100 crore then as a minimum Rs 65 crore or more needs to be invested in equities.
When investing into any mutual fund scheme investors are obligatory to select one among three options, they are growth, dividend payout or dividend reinvestment.
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