Mystery of Dividends – Stock Vs Mutual Fund

I was talking to a friend about dividends in stocks and he suddenly came up with “What are dividends in mutual funds?”. I said it is different. Here is the answer:

Stocks : When an investor purchases a share of a company, he is essentially owning some part in the company.  Dividends are payments made by a company to its shareholders. When a company earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. A dividend payout typically indicates that the company has confidence in earnings growth and sufficient profitability to fund future expansion. Also for investors, it makes sense to earn that extra income for investing in the company, rather than waiting for the share price to rise up to get the profit.

Mutual Funds : When an investor purchases units of Mutual Fund, he is essentially contributing to the mutual fund corpus (similar to thousand others), which the MF will invest in various shares. The price at which these units are purchased at any particular time is called NAV. The problem with mutual fund NAVs is that when a mutual fund declares dividends, the NAV is affected.

For example, say for an XYZ mutual fund scheme, the NAV today is Rs 50. If the mutual fund declares a dividend of Rs 2 per unit. So if an investor has bought 100 units, he will get Rs 200 as cash. The problem is that this immediately reduces the NAV to Rs 48 (Rs 50 – Rs 2). Hence essentially the investor’s remaining worth has been reduced by Rs 200.

So whatever profit an investor has made due to increase of NAV, MF has given some part of it as cash back to the investor and called as dividend. The net worth of investor remained same, just that he has received some of it in cash.

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