We received an incredulous call from one of our financial planning clients. He claimed he had lost capital value when he had invested some large surpluses in a liquid fund. He claimed when he withdrew the entire investment last month, he got back less than the amount invested in January. Liquid funds are safe, hence, there was no question of any loss being incurred. We asked him for details.
We learnt the client had invested Rs 3 lakh on January 10, 2013. Net asset value (NAV)= Rs 2,179.23; allotment = 137.66 units. On March 25, he received a dividend of Rs 65,603, which was reinvested as he had chosen a dividend reinvestment option. The NAV at this point of time was Rs 1,592.4214 and, therefore, an additional 41.197 units were credited to his account. Thus, the total number of units stood at 178.86.
The invested amount reduced on March 26 to Rs 284,820, that is, NAV (as on date) multiplied by the number of units (1,592.4214&178.86). Had he invested in the same fund but opted for growth option, he would have earned a return of over eight per cent a year.
Clearly, the issue was the whopping dividend paid. It brought down the NAV by more than the dividend amount. The dividend is tax-free in the hands of the unit holder, but the fund has to pay it, called Dividend Distribution Tax (DDT). DDT paid by the fund is debited back to the unit-holder by reducing the NAV.
Now, if the dividend was restricted to the amount of gain made on the unit, our client would not have been any worse off, as the tax paid by the fund would have been less than or equal to the amount he would have to pay anyway. However, in this case, DDT had also been paid on the capital returned and that is what was causing a loss to him.
Suppose you lend Rs 100 to somebody at 12 per cent annually. At the end of 10 months, the principal-plus interest works out to Rs 110. At this stage, you want your money back. The interest portion is paid back as dividend. The borrower pays tax for that and returns the principal amount after deducting the tax. If the fund pays tax on your behalf at the same rate as you would have paid, then it is a no loss-no gain deal. It would have worked better if you had asked for the Rs 110 and paid tax on the Rs 10 yourself.
Suppose the borrower offers to pay a dividend of Rs 60 and returns after deducting the tax paid on the dividend. Clearly, it's not a good deal for you because here the tax paid on the entire Rs 60 is being deducted from the amount due to you.
Paying Rs 60 as dividend when the interest portion is only Rs 10 is absurd. Let me just say this is what happens when you invest in a liquid fund when it has accumulated gains in the past, which have not been declared as dividend. When they do declare the dividend, the unitholders who have joined later may end up getting a dividend that will reduce the NAV below their cost price.
I can think of very limited options under which the dividend option would work out better for an individual in any liquid fund. In fact, when the withdrawal happens after one year, the growth option confers a significant tax benefit. Even for equity funds, the dividend option does not make sense and can cause tax losses due to units being redeemed within one year of dividend declaration.
So, for an individual investor, it makes sense to go for the growth option when investing in a mutual fund.