How do Mutual Funds Pay Dividends?

All mutual funds have certain properties in common – diversification, liquidity, and professional management by a fund house. When you explore mutual funds, you will find high dividend-yielding funds are generally recommended for risk-averse investors who expect a regular income from their investments.

These funds distribute dividends to investors, which can become a passive income source for them. How do these dividend-yielding mutual funds pay dividends? Do they distribute all their profits as dividends, limiting the fund growth? Read this blog to find out. 

Overview of Dividend Yielding Mutual Funds

Dividend-paying mutual funds invest in income-generating assets like dividend stocks, bonds, and REITs. These funds distribute a portion of their earnings to investors as dividends, usually on a quarterly or annual basis. Here are the key points:

• These funds provide regular income, making them appealing to income-focused investors.
• Primarily invest in dividend-paying stocks, bonds, or REITs.
• Dividends are paid out in cash or reinvested to buy more shares.
• They suit those seeking stability and consistent income rather than high growth.
• Dividends are subject to tax based on the income tax slab rate. 

How Mutual Funds Pay Dividends

Mutual funds invest in multiple markets, such as securities and debt, based on the fund allocation. The fund manager manages the fund's diversified portfolio to earn income. The underlying investments generate revenue in the form of interest from bonds, stock dividends, and capital gains. These are the earnings of the mutual fund and are shared with the investors as dividends. 

The fund house accumulates these earnings, deducts expenses and distributes profits based on the share ownership among mutual fund investments. Depending on whether you have chosen a growth or Income Distribution Cum Capital Withdrawal (IDCW) plan, the dividend is either reinvested into the mutual funds or paid out to investors. 

With the reinvesting option, the investor simply buys more units of the mutual fund based on the dividends they are entitled to. Due to compounding, this type of reinvesting results in potentially increasing returns from the mutual fund. Those who need regular income from their mutual funds can use the IDCW option. 

How Mutual Funds Determine Dividends 

Based on the fund manager's strategy, the mutual funds earn different types of income. The total income is computed at periodic intervals based on the type of mutual fund. Expenses incurred for managing those funds are subtracted from the income. The remaining is the profit from the fund. 

Mutual funds are required to disperse profits to investors to ensure that they don't pay hefty taxes on investment income. So, the shareholders of the funds benefit from the income made by the mutual fund portfolio. Individual investors must then file these dividends as their income and pay taxes based on the earned income. 

The mutual fund distributor determines the payout time of these dividends. Generally, dividend-yielding mutual funds pay dividends at least once annually. Some liquid funds may even pay dividends on a daily or monthly basis. 

If the asset management company doesn't pay dividends within the time frame, then it must pay interest on the dividends to the investors. 

Impact of Dividends on NAV

Distributing the dividends among investors curtails the growth of the mutual fund as the profits are not retained and reinvested. Thus, it impacts the mutual fund units' Net Asset Value (NAV). Compared to mutual funds that don't announce dividends, dividend-paying funds have a lower NAV. With dividend-paying funds, NAV changes drastically, especially after the announcement of dividends. 

The NAV will be reduced by the dividend amount on the ex-dividend date. This is a direct reflection of income distribution to the investments. The fall in NAV happens because dividend distribution triggers a fall in the total net asset value. 

For example, if the NAV of a fund is Rs 20 per share and the fund house announces a dividend of Re 1 per unit, the NAV of the fund will then fall to Rs 19 per unit during dividend distribution. However, due to growth in mutual fund investments, the NAV may balance out in the future. 

With dividend-paying mutual funds, even when the NAV decreases during dividend distribution, the NAV can increase when the underlying investments grow in value. Any change in the total market value of the underlying assets will result in a change in NAV. 

How to Choose Mutual Funds Based on Dividends?

When you compare mutual funds, the ones with higher yields are attractive. However, it must not be the only metric you choose for comparison. Other factors you must consider are:

• Look at Sustainability: Dividend yield is the percentage of a fund’s NAV paid out as dividends annually. Higher yields typically indicate larger payouts but could also signal higher risk. Compare the yields of various funds, but consider consistency and sustainability, not just the highest payout. Extremely high yields may indicate potential risk or unsustainable payouts. 
• Consider Your Goal: Choose funds with a strong dividend-paying track record if you seek steady income. If growth is a priority, focus on funds that reinvest earnings rather than pay high dividends.
• Evaluate Performance: Look at the fund's performance over time, particularly its ability to maintain or grow its dividend payments. Consistent payments suggest reliable management and stability. Check the fund’s history of dividend distributions. A fund that regularly adjusts or increases its dividends indicates solid financial health and effective management.

Conclusion

Dividend-paying mutual funds are ideal for investors seeking a reliable source of income. The fund house announces dividends based on the income from the underlying assets. Even though most mutual funds pay dividends annually, the timeframe depends on the decisions of the fund house. Based on your goals, you can choose dividend payout or reinvest dividends into your portfolio to increase returns from your investment. While comparing funds, pay attention to sustainability, performance, and dividend yield to choose the best investment.