Do not rely on Dividend from Equity or Balanced funds for regular income

I came across a Whatsapp message recently that a prominent balanced fund was offering dividend of 1% per month. And those seeking monthly income could consider these funds.

In January 2016, HDFC AMC fixed the frequency of dividend distribution  for HDFC Prudence Fund to monthly i.e. dividend will be paid out every month.  Quantum of dividend cannot be guaranteed upfront.

What is the track record since then?

The fund has indeed paid dividends every month since then (in both regular and direct plans). From April 2016, the fund has paid dividend of Rs 0.3 per unit per month.

The NAV of the scheme hovers around 30 and it offers a dividend of Rs 0.3 every month. That makes it 1% per month.

That clearly seems a marketing strategy from HDFC AMC. It announced a monthly dividend and paid a consistent dividend for 10-12 months.

Now, the intermediaries can approach investors and give the impression to investors that they get ~1% per month in the form of dividends. HDFC AMC cannot guarantee dividends openly but intermediaries can always convey this message verbally.

By the way, I am not saying HDFC AMC has done anything wrong. Paying a stable monthly dividend is a perfectly acceptable marketing strategy.

However, if HDFC AMC or the intermediaries are actively working in the background to give the impression of a regular income, it is not in the right spirit. To me, this tantamounts to mis-selling.

Is it a good deal?

If you invest Rs 10 lacs, you will get approximately Rs 10,000 per month and that too tax-free.

1% per month. 12% per annum. At a time when fixed deposits are struggling to offer 7% p.a. pre-tax, you are getting 12% per annum post-tax.

Sounds like a really good deal, doesn’t it?

Not really. There are many problems with this approach.

#1 Dividend is not Profit

Dividend is paid from your money only and the fund NAV goes down by the amount of dividend. For instance, if the NAV is Rs 30 and dividend of Rs 0.5 is paid subsequently, the NAV will go down to Rs 29.5.

If you feel dividend is an additional income for you, you are wrong.

In the growth option (where dividend is not paid), NAV would have stayed at 30 while the NAV in dividend option has come down to 29.5.

#2 Dividend is NOT guaranteed and can be paid only from Profits

Dividend can only be paid from the surplus (profit) generated by the fund.

In case of a market downturn, the ability of the fund manager to distribute dividend can be compromised since there may not be any distributable surplus.

The dividend may even be skipped in such a case.

What will you do then?

#3 You don’t control the quantum of Dividend

The fund manager (and the AMC) does. I concede he can’t be completely arbitrary.

AMC has to keep promises made to distributors, advisors and investors in mind. Therefore, fund manager may try to give stable dividends.

However, as discussed earlier, not everything is in his control.

Rs 0.3 per unit this month may become Rs 0.2 per units. So, if you received Rs 30,000 last month, you may get only 20,000 this month.

Read: Why SWP from an equity fund is a bad idea?

PersonalFinancePlan Take

To me, dividend option in equity funds makes little sense.

Dividends from equity funds are exempt from tax. Long term capital gains (Holding period >=1 year) are exempt from tax too.

Therefore, I see no additional tax benefit in investing in dividend option of equity funds (as compared to growth option).

You invest in equity funds only for the long term (at least 7-10 years).  Once your investment is over a year old, you can simply sell the units as per your need. You do not need dividend.

For instance, if you need Rs 10,000, you can simply sell units worth Rs 10,000. You don’t have to hope to get a monthly dividend of Rs 10,000.

You control how much you can sell but you don’t control the quantum of dividend.

However, by merely focusing on growth and dividend option of equity funds, we are missing a much bigger point.

You should NOT rely on equity funds for regular income in the first place.

It is a poor approach. Not just dividends, even SWP from an equity fund to generate regular income is a bad idea. Both dividend and growth option in equity funds are unsuitable for regular income.

If you want regular income, you must look towards lower volatility assets such as debt mutual funds or fixed deposits. In case of debt funds, the choice between dividend and growth option will depend on your marginal income tax rate and investment horizon.

Therefore, next time, someone approaches you to invest in an equity fund for regular income in form of dividends, you know what to do.

Book Suggestion: Bogle on Mutual Funds (New Perspectives for the Intelligent Investor) (John C. Bogle)