Return on capital vs return of capital

Mutual fund dividends are a misnomer, for it is essentially your own money paid back to you

Let’s say I borrow Rs10,000 from you today and promptly return Rs2,000 in a couple of days such that I now owe you Rs8,000. Will you consider your return on investment to be 20%? Obviously not. Only if I was to pay you the Rs2,000 and yet continue to owe Rs10,000 would you say the return is 20%. The fact that I paid back Rs2,000 such that I owed you that much lesser, it is return OF capital and not return ON capital. That’s as straight as it gets.

However, many mutual fund investors mistake a return of capital for a return on capital.

Any dividend received from a mutual fund is essentially return of capital and not return on capital. The difference is moot, since an unclear understanding of this concept is being misused by many distributors to shove undeserving investments down an unsuspecting investor’s throat. This is especially true in the case of equity linked tax saving schemes (ELSS) where large dividends are doled out as March 31 approaches and investors are invited to invest based on the lure of a quick return on capital.

The problem is on account of usage of the term ‘dividend’ in relation to mutual funds. Investors mistake it to have a similar significance as the term has with respect to stocks. Now, when Infosys gives you a dividend, it transfers money from its pocket to your pocket. To that extent, Infosys becomes poorer and you become richer. However, when a mutual fund gives you dividend, it is transferring money from your left pocket to your right pocket. Post the dividend, neither is the mutual fund poorer nor are you any richer. It is only your money coming back to you. In other words, the value of your investment (NAV) falls to the extent of the dividend.

For example, as on March 31, the NAV of the growth option of HDFC Equity Fund was Rs165.79, whereas that of the dividend option was Rs38.25. The difference of Rs127.54 per unit is largely nothing but your own money paid back to you (by calling it dividend). The investor who has chosen not to receive the dividend is owed Rs127.54 per unit by the scheme, whereas an investor choosing the dividend option is owed only Rs38.25. Now, can you find similarities between the example that we started out with and this one?

The pitch becomes even more bizarre when it comes to ELSS funds. Let’s say the NAV of an ELSS fund is Rs100. It whispers to the distributor (Sebi doesn’t allow a loud declaration of the impending dividend prior to five days of the record date) who in turn whispers to the investors that the scheme is set to announce a dividend of say 250% or Rs25 per unit.

The proposal is one that cannot be refused — 25% return from dividend (Rs25 divided by Rs100 per unit initially invested) plus 30% return due to the tax-saving, making a total of 55% return on investment. And this is just on the basic capital invested, if the scheme performs well, it will be additional icing on the lucrative cake. Now, let’s see why this boils down to downright cheating.

First, as explained earlier, the 25% return is not on capital but of capital. As soon as you receive the Rs25 as dividend, the NAV falls to Rs75. The 30% tax deduction is spread over three years of lock-in, so at best it is 10% per annum.

It must be said that over the years, Sebi has been doing an excellent job of regulating the mutual fund industry. From putting caps on expenses that can be charged by a scheme to the percentage of investments that can be made in a single stock or in any one industry to the more recent changes introduced like banning open ended funds from charging initial issue expenses, introduction of no-load funds and making bonus and dividend reinvestment units load-free etc, the regulator has been doing what it can to protect investor interest.

Readers may remember that mutual fund NFOs were once called IPOs. To enable investors to differentiate between a mutual fund IPO and a company IPO, and prevent any mistake on the investors’ part or mis-selling on the distributors’ part, the term NFO for new offers from mutual funds was introduced.

It is time something similar was done in the case of mutual fund dividends.

My suggestion is to drop the term ‘dividend’ altogether and classify all income from mutual funds as capital gain. When the mutual fund pays you money, it is called a dividend; when you yourself withdraw an equivalent amount, it is called capital gain. The amount is the same, but the terms and tax treatments are different. This is not desirable — especially considering the way it is being misused by vested interests at the cost of lay investors. One only hopes the Sebi chairman, C B Bhave, with take note of this.

sandeep.shanbhag@gmail.com