The Hindu Business Line : Do dividends increase returns?

One of your columns made the point that whether you buy into a fund with a high NAV or one with a low NAV cannot make a material difference to returns. I have a query on this. Suppose I invested Rs 10,000 in two funds — one with an NAV of Rs 100 and another with an NAV of Rs 10. This would fetch me 100 and 1000 units respectively. Both funds declare a dividend of Rs 2 per unit.

Won't I get a higher return on the second fund, because I own more units? The same logic would hold good if the fund declares a bonus. Could you clarify?

P. Rajagopalan

Bangalore

Let us first reiterate that the number of units you own does not determine your returns. To understand why, you need to know that dividends (or bonus units) distributed by a fund do not add to your returns from the fund.

What really determines returns is the appreciation that the fund manages to earn on the stocks in its portfolio. If a fund pays out a dividend, this comes out of the returns it has already earned on its portfolio and has captured in its NAV.

To illustrate, consider a fund managing a portfolio worth Rs 10 lakh. If this grows to Rs 20 lakh over three years, the fund has earned a 100 per cent return.

Assuming the fund has a lakh of units outstanding, the NAV of the fund would have climbed from Rs 10 per unit (Rs 10 lakh divided by the number of units) to Rs 20 per unit over the same period. Having earned this appreciation on its portfolio, the fund may choose to distribute it as a dividend to its unitholders or plough it back into investments.

In either case, the returns would accrue only to the unitholders of the fund.

In the above case, let's say the fund chooses to distribute Rs 5 lakh out of the Rs 10 lakh it earned as dividend to its dividend option unitholders.

If I opted for the dividend option, I will receive Rs 5 per unit as dividend, but the NAV of the remaining units I hold will fall to Rs 15 per unit. Therefore, my return from the fund till date will be at 100 per cent (50 per cent through dividend, and 50 per cent through capital appreciation on the NAV).

If I hold the growth option, I will not receive any dividend, but my share of returns earned from the fund will be captured in the growth options' NAV, which is Rs 20 per unit. My return in this case, too, will be 100 per cent (only through capital appreciation on the NAV).

This example makes it clear that a fund that pays out a dividend is not necessarily superior to a fund that has not paid out any dividend.

What matters is the appreciation that the two funds have earned on their NAV, before any dividend payouts.

Coming back to your query, consider two funds — one with an NAV of Rs 100 per unit and another with an NAV of Rs 10 per unit. If both earn an appreciation of 20 per cent on their portfolio, the fund with the NAV of Rs 100 per unit will see its NAV go up to Rs 120. It will have a surplus of Rs 20 per unit to distribute as dividend.

The fund with a NAV of Rs 10 per unit will have just Rs 2 to distribute as dividend. Therefore, an investor holding 10 units of the "high NAV" fund will earn the same quantum of dividend as the one who holds 100 units of the "low NAV" fund.

Much like dividends, bonus offers from funds do not make any difference to your returns. A bonus offer merely helps to spread the value of a fund's portfolio over a larger number of units and will not affect the value of your holdings in a fund. Investors may, however, choose to invest in dividend or bonus options because they help reduce the outgo on capital gains tax.

Queries may be sent to: mf@thehindu.co.in or by post to Q&A, Business Line, 859/860, Kasturi Buildings, Anna Salai, Chennai - 600 002.

Aarati Krishnan