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B. Venkatesh

BIRLA Sun Life Mutual Fund's decision to announce that it has set March 12, 2004 as one of the record dates for declaring dividends in Birla Advantage Fund does not bode well for the mutual fund industry. The reason is that announcing record dates three months in advance will attract more dividend strippers, who are primarily institutions and high net worth individuals (HNIs). This class of investors may now demand other mutual funds to also declare their record dates in advance.

The problem arises because dividend plans also have retail investors who are not dividend strippers. This class of investors will suffer because dividend stripping leads to sub-optimal returns. Mutual funds should, hence, ensure that institutions do not invest in the plan that primarily caters to the retail investors. Moreover, managing separate portfolios can eventually discourage dividend stripping due to impact-cost- tax-benefit trade-off.

Dividend stripping: The tax treatment for dividend-paying instruments is different from comparable non-dividend paying instruments. Suppose an investor buys units in a fund in December for Rs 20 per unit. He receives a dividend of, say, Rs 3 per unit in March 2004. If the investor redeems the units at an NAV of Rs 18 three months after the payout, he can claim short-term capital loss of Rs 2 per unit because his cost was Rs 20. The Income-Tax Act allows for such a treatment. If the investor had instead bought units in Growth plan, and the NAV is Rs 21 in June 2004, the investor will be required to pay capital gains. This difference in tax treatment has resulted in dividend stripping in mutual funds by HNIs and institutions.

The problem with dividend stripping relates to managing cash flows. When mutual funds announce record dates for dividend distribution at least three months in advance, the case for dividend stripping only increases. This results in heavy cash inflow into the fund three months before the dividend payout, and heavy outflow three months later. Such cash flows may lead to sub-optimal portfolio construction.

Sub-optimal portfolio: A mutual fund that receives large inflows from investors wanting to take advantage of dividend stripping suffers from concentration risk. This is the risk of the NAV declining because of overexposure in one asset. An equity fund with a large asset base may, for instance, have high exposure to State Bank of India. If the stock price of this company declines, the NAV will fall sharply.

The concentration risk is directly proportional to the asset size of the fund; higher the asset size, higher the risk. The reason is that the portfolio manager, expecting cash outflows three months after the payout, has to invest in the small universe of highly liquid bonds and stocks.

An added problem is that the portfolio manager may have to offload assets to meet redemption from dividend strippers three months after the dividend payout. This results in sub-optimal returns for two reasons. One, the portfolio may suffer impact cost.

This is the cost of realising lower price because the portfolio manager sells large quantity of a stock in the market. And two, the portfolio manager may be forced to sell the most profitable positions too soon. Both factors harm the long-term unit-holders of the dividend plans.

Suggestion: Mutual funds should strictly manage separate portfolios for institutions and retail investors. At present, most mutual funds do have institutional plans, but this class of investors still invests in the regular plan that caters to the retail investors. The reason, perhaps, is because retail investors subsidise the impact cost for institutional players.

If all dividend strippers were to invest only in the institutional plan, the portfolio manager may have to, perhaps, offload the entire portfolio three months after the dividend payout. This process of moving into cash will lead to high impact cost. If the impact cost is higher than the benefit derived from dividend stripping, institutional players stand to lose.

In a regular plan, however, this cost is borne by the retail investors who continue to stay invested in the fund. Managing a separate portfolio can, therefore, not only protect retail investors from suffering sub-optimal returns but also prevent large-scale dividend stripping, a legal fiction created by the Income-Tax Act.

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