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Aarati Krishnan

WITH equity funds notching up stellar returns over the past six months, dividend announcements from equity mutual funds have been coming thick and fast. On the face of it, this is a healthy trend for retail investors in equity funds. It is the fund manager's way of ensuring that investors cash in on the high returns that have been available from the equity market over the past six months. It is not often that equity fund NAVs shoot up by between 30 per cent and 80 per cent in just six months. The dividend payouts ensure that fund managers and investors have booked profits on a part of their portfolio when the going is good. Profit booking leaves them that much richer with cash in their hands, if the equity market decides to retrace its steps.

But dividends from equity funds can also be misused. Remember that equity funds continue to be convenient vehicles for dividend-stripping. After the recent run-up in equity values, institutions, big investors and even retail investors with a small equity portfolio are likely to be flush with capital gains, from booking profits on their stocks.

Dividend-stripping likely

Now, these investors would have to fork out between 10 per cent and 30 per cent of these capital gains by way of income-tax, depending on whether the stocks sold have been held for less than a year (short-term gains) or over a year (long-term gains).

Dividends from equity funds offer a convenient means for these investors to save on capital gains tax. Investors entering an equity fund just before the record date for its dividend announcement will make a notional capital loss on investment after the NAV turns ex-dividend (the NAV will drop to the extent of the dividend payout per unit, the day it turns ex-dividend). If the investor exits the fund shortly after the dividend declaration, he stands to make a "capital loss" on paper, which can be used to set off capital gains from his equity holdings. Such dividend stripping has no doubt been made more difficult by the changes in tax laws over the past couple of years. Investors entering before the dividend announcement now have to stay with the fund for at least 90 days, after the NAV turns ex-dividend.

But even a 90-day lock-in may not deter an investor who stands to make substantial tax savings through dividend stripping. In a strong bull market, it may well seem worth the wait. If the fund's NAV does not climb substantially from the ex-dividend level, he can book a capital loss on his investment and reduce the capital gains tax on profits booked on stocks. On the other hand, if the fund's NAV continues to climb after the dividend declaration, there may be a lower capital loss, but he would still be a net gainer as the value of his investment would have appreciated.

Potential to backfire

But even short-term investors in equity funds should be wary of the fact that dividend-stripping has the potential to backfire, especially in the present market conditions.

An entry into an equity fund in an overheated market will leave you vulnerable to any sharp reversal in equity values and, thus, on the NAV of your fund. The 90-day lock-in period only enhances the risk.

The lock-in period will effectively prevent you from pulling out of the fund at the first signs of a market correction. There is also the danger that you will also lose out on any benefits from dividend stripping, if your case catches the taxman's eagle eye (tax laws allow the assessing officer to penalise transactions which appear to be entered into just for the purpose of avoiding tax.)

If it has the potential to backfire on short-term investors, the practise of dividend-stripping can be quite harmful to the interests of long-term investors in an equity fund.

Substantial inflows into a fund, which stay for as short a period as three months, may have a destabilising effect on fund management.

It may force the fund manager to allocate a larger proportion of his investments to near-cash instruments which will definitely impact returns.

Substantial inflows into the fund at the height of a bull market may also force the fund manager to acquire stocks at high prices and can dilute long-term performance.

Looking the other way

But despite the obvious ill-effects of dividend-stripping, fund houses do not seem to be doing enough to discourage the practice. Quite a few fund houses have adopted the practice of announcing the record date for dividend declarations well ahead of the actual event.

There is also the recent trend of fund houses waiving the entry load on investments made in substantial chunks of Rs 20-25 lakh, which suggests that they are laying out the welcome mat for institutional money.

Clearly, it is up to SEBI to take note of these practices and discourage them. Otherwise, equity mutual funds may go the way of debt products.

They may end up as treasury management tools for large investors, rather than being channels for redirecting the surpluses of retail investors into the capital market.

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