Returns from an investment can come from market-price appreciation or payout from the investment itself, or both. In equity shares, returns come mostly from price appreciation and, to a limited extent, from dividends paid by the company.
In bonds, returns come mostly from the coupon or interest payouts from the issuer of the bond. If a bond is held till maturity, then there is no market price-related gain or loss as it is redeemed at face value.
A mutual fund (MF) is a vehicle for investment in instruments from the market (such as equity shares and bonds) and distribution of the returns to unit holders.
The distribution of returns in MFs is done in two ways that are largely similar but slightly different. In the growth option of MF schemes, there is no separate pay out; it remains in the net asset value (NAV) and investors get their returns as and when they redeem at the NAV, which is higher than the earlier NAV.
In the dividend option of MF schemes, there is periodic payout of dividends. Apart from this, investors can redeem as and when they want at the prevailing NAV. The NAV of the dividend option, at the time of redemption, may be higher than the earlier NAV or similar, depending on the extent of dividend payouts.
Mis-selling a product
The relevance of the above discussion is that sometimes some products are not sold in the right spirit. The dividend option is highlighted to investors as if it is some extra return such as a bonus. If the earnings in an MF scheme is not distributed in the form of dividend, it will remain in the NAV. As and when the investor redeems, she or he will get returns based on the NAV.
An example of this kind of mis-selling is selling balanced funds (now aggressive hybrid funds) on the basis of 1% dividend per month. Dividend in an MF scheme is not a commitment and is dependent on market conditions. This 1% dividend per month was touted as a committed return over and above the NAV-based returns. A mutual fund is a vehicle for long-term wealth creation. It is not a Post Office Monthly Income Scheme.
SEBI has stepped in now. In a circular dated October 5, applicable from April 1 next year, it has been stated that all dividend options shall be named Payout of income distribution cum capital withdrawal option. Though it is a change of nomenclature only and not any restriction or other change in dividend, it is significant. It will not give the sense of something extra or a bonus being given out, but of means of income distribution, which it actually is.
If you invest straight away in an equity share or bond, the extent of the payout makes an impact on your returns, but in an MF, it is just a method of distribution of income to unitholders.
Whats in a name?
Sometimes, a name may carry a different implication to people who are not in the thick of things.
A long time ago, when an MF came out with a scheme, it was called an initial public offer and in certain sections, it used to be marketed as IPO at par. These used to be marketed on the pitch that with the NAV of other (older) schemes being higher, say 20 or 30 the investor was getting a good bargain as it was available at par, say 10. To restrict this convoluted logic, SEBI stipulated that these offers should be called new fund offers (NFO) and not an IPO, so that the investors do not confuse this with an equity IPO.
Similarly, while dividend is apparently an innocuous word, the misuse of the term by certain sections prompted SEBI to rename the dividend option. On your part, if you do not require regular cash flows, you need not opt for dividend option/payout of income distribution option. The growth option houses the gains in the NAV and you can redeem as and when you want, subject to any exit load implications.
(The writer is a corporate trainer debt markets and author)