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Understanding dividend investing: should you invest in stocks or mutual funds for dividend income?

This article explains the concept of dividends and shows which option is better for dividend income: stocks or mutual funds.

Understanding dividend investing: should you invest in stocks or mutual funds for dividend income?


Posted on 10 May 2023
Author: Sayan Sircar
7 mins read
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This article explains the concept of dividends and shows which option is better for dividend income: stocks or mutual funds.

Understanding dividend investing: should you invest in stocks or mutual funds for dividend income?

📚 Topics covered:

What is a dividend?

A dividend is a share of the profit of a company given to the owners of the company. For example, if the company is a shop, the shopkeeper can use say 30% of the monthly profits for household expenses. The remaining 70% of profit is used to grow his shop and is called retained earnings.

If there are two shop owners, say two siblings, they will share the profits from the shop in proportion to their ownership. Any amount not taken by the owners becomes retained earnings.

A loss-making company cannot pay dividends.

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Getting dividends from stocks

Dividends allow company owners to take part in a company’s profits.

Stock dividends operate in the same way as the shop example. Here is a quick explainer of the concept:

🤖 Explainer: Dividends from shares

Dividends are payments made by companies to their shareholders to distribute a portion of their profits. These payments are typically made regularly, such as quarterly or annually.
However, they can vary in amount depending on the company's performance. As a result, some stocks may offer higher dividends than others, and it's essential to consider a company's financial health and dividend history before investing in their stock. It's also important to note that not all stocks pay dividends. Some may reinvest their profits into the company instead.
Dividends are taxable at the slab rate of the investor.

Getting dividend income from a mutual fund

Mutual fund assets before dividend = Stocks + Cash

Mutual fund assets after dividend = Stocks + Cash - Dividend

Since NAV = Fund Assets / Units, NAV falls after dividend payout.

Mutual funds do not provide dividends in the way stocks do. Mutual funds do have a dividend plan called Income Distribution cum Capital Withdrawal (IDCW), but that is just returning a part of the cash balance of the fund to the investor. As a result, the NAV falls by the declared dividend amount. In addition, mutual fund dividends are taxable at the investor’s slab rate, like stock dividends.

Do dividends beat inflation?

We will consider the BSE SENSEX as a representative of Indian stocks and compare the return of the SENSEX vs that of the SENSEX Total Return Index (SENSEX TRI). In the TRI version of any index, the stock dividends are immediately reinvested into the portfolio.

We have limited data since historical TRI index data was available only since 1996 and therefore restricted ourselves to only 20-year windows for rolling period analysis.

Sensex difference of price index with total return index

As the chart shows, including the 1-2% dividend yield has drastically improved the value of the SENSEX from 60,000 for the PRI version to more than 90,000 for the TRI version.

Average SENSEX dividend return for 20-year holding periods

Suppose we plot the total dividends from a portfolio investing in the SENSEX TRI, via a mutual fund, for every period of 20 years and calculate the CAGR returns. In that case, we will get a chart like the above one. We have 69 periods, each 20-year long, from Aug-1996 till date. These periods are:

  • Aug 1996 to Jul 2016
  • Sep 1996 to Aug 2016
  • and so on

In most of these 20-year holding periods, the total amount received from dividends has grown faster than an inflation rate of 7%.

Should we replicate the SENSEX by buying the underlying stocks to get dividends?

Investors should avoid investing in direct stocks, whether that of the SENSEX or by following any dividend strategy, because of the following reasons:

  • the amount received as dividends will be spread out throughout the year. With mutual funds, it is easier to sell units once a year for the amount desired
  • to maintain a high dividend yield, there is an element of active management of the stock portfolio with buys and sells that require a significant time commitment
  • selling stocks require payment of capital gains tax which does not happen when a fund manager sells stocks inside a mutual fund
  • the SENSEX has 30 stocks which are difficult to track and maintain. A portfolio with a smaller number of stocks is less diversified and requires expertise that few investors will have

Currently, dividends in India are taxable at slab rates. This means that as per the RRTTLLU suitability framework, dividend-paying stocks are unsuitable for the accumulation stage, i.e. pre-retirement portfolio. In post-retirement, there is a possibility of taxes being lower, making dividends more tax-friendly. Even at the highest slab rates, the chance of stable income from dividends must be balanced against the lower taxation from stock and mutual fund capital gains.

Due to the reasons above, an investor, at higher slabs, looking to create a stream of dividend income should invest via a mutual fund and not via stocks.

How to invest in mutual funds for dividend payouts?

Returns, including dividends, from mutual funds are not guaranteed.

Mutual funds come in two plans:

  • Growth plans which reinvest the dividends
  • IDCW plans which pay out the dividends

Irrespective of whether we need the dividend, we should only invest in the Growth plan of the mutual fund. Here are the supporting reasons:

  • Dividends from the mutual fund are taxable at slab rates while capital gains are taxed lower at 10% of profits above ₹ 1 lakh/year for long-term (more than 1-year holding) gains and 15% of the profits for short-term (less than 1-year holding) gains as explained here: How is tax calculated on selling shares/MFs?
  • Dividends from mutual funds are not guaranteed, and funds may or may not follow a fixed schedule for payout
  • The amount of dividends received depends on the fund’s payout policy and does not have any relationship with the amount of dividends received from the stocks in the fund

As a simple rule, the investor can sell 1-2% of their mutual fund units every year since that amount is close to the historical dividend yield of the SENSEX. Therefore, in summary, to get dividends by investing in mutual funds, an investor should:

  • choose an index fund tracking a broad market index like the SENSEX or the Nifty 50
  • sell enough units to cover 1-2% of the fund market value once a year. The index dividend yield is available on the BSE (for SENSEX) or NSE (for Nifty 50) websites
  • pay capital gains tax on the units sold, if any, and then utilise the dividends

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This post titled Understanding dividend investing: should you invest in stocks or mutual funds for dividend income? first appeared on 10 May 2023 at https://arthgyaan.com


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