What is IDCW in Mutual Funds and Should You Consider this Option?

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  • May 20, 2022 - What is IDCW in Mutual Funds and Should You Consider this Option?

What is IDCW in Mutual Funds and Should You Consider this Option?

May 20, 2022

What is IDCW in Mutual Funds and Should You Consider this Option?

When you invest in a mutual Funds scheme, you have broadly two options -- go with the Growth Option or choose the Income Distribution cum Capital Withdrawal (IDCW) option. The latter was earlier known as the dividend option.

However, the capital market regulator, SEBI, vide a circular dated 5 October 2020 directed all mutual fund houses to rename the Dividend Option. As a result, starting from 1 April 2021, mutual funds renamed the dividend option as the IDCW.

The objective behind this was to use the correct nomenclature and give investors a better understanding to investors that mutual do not pay 'dividends' -- as in the case with stocks -- but if some chooses this option while investing in mutual funds, it connotes 'Income Distribution cum Capital Withdrawal'.

Table 1: IDCW is the new name for the dividend option...

Old terminology New Terminology
Dividend Payout Payout of Income Distribution cum capital withdrawal option (IDCW)
Dividend Re-investment Reinvestment of Income Distribution cum capital withdrawal option (R-IDCW)
Dividend Transfer Plan Transfer of Income Distribution cum capital withdrawal plan (T-IDCW)
(Source: SEBI)

Some mutual fund investors among you might feel that except the terminology, nothing has changed but don't miss the most crucial point about dividends paid by mutual funds.

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The fundamental difference between dividends paid by mutual fund schemes and those paid by companies is predictability and probability.

A company pays dividends out of the profits earned through its business activities. In most cases, companies have well-documented dividend policies and perhaps a track record which makes their dividend payouts slightly more predictable.

For instance, Public Sector Undertakings (PSUs) are obligated to pay a dividend of at least 30% p.a. of their profit or 5% of their net worth, whichever is higher.

Unlike that, dividends declared by mutual fund schemes are subject to distributable surplus which is a function of market conditions and the performance of the scheme.

Dividend declaration by a mutual fund scheme is at the discretion of the fund manager; nothing is binding on him/her to do so. Therefore, dividend income on your mutual fund investments can never be regarded as a dependable source of income.

Here are some myths associated with dividend distribution by mutual fund schemes:

  • Dividend declaration by a mutual fund scheme is an indicator of the scheme's performance.
  • Under the dividend option, the fund manager regularly books profits to pay dividends.
  • The dividend option has a lower NAV and therefore translates into a better buying opportunity.
  • Dividends earned by the portfolio constituents are passed on to unitholders.
  • Dividends earned can be a regular source of income.
  • Opting for the dividend option lowers the risk associated with mutual fund investments since profit booking happens at regular intervals.

None of this is true.

So, to sort of debunk these myths and help distinguish from the Growth Option, the regulator renamed the Dividend Option to IDCW.

Besides, in the past, some mutual fund houses made dividend payments a marketing tool to garner AUM into their schemes.

If you remember, Aditya Birla Sun Life Tax Relief 96 Fund paid a cumulative dividend of Rs 101 between December 2006 and March 2007. Dividends declared by equity schemes were tax-free then in the hands of investors, and so were the capital gains from equity assets if the holding period was more than a year.

The marketing pitch of the distributors was simple. If you invest Rs 1 lakh (maximum deduction available then u/s80C) in Aditya Birla Sun Life Tax Relief 96, you will recover most of your investments before the lock-in period of 3 years ends by way of dividends.

Many gullible investors felt that their investments in the fund will generate a great return over and above these dividends.

In the recent past, some equity-oriented hybrid funds took a leaf out of Aditya Birla Sun Life Tax Relief 96's book. They declared monthly dividends from their realized, undistributed profits accumulated over the years. This became a unique selling point for many of them.

Senior citizens and conservative investors seeking regular income looked upon regular dividend-paying mutual fund schemes as attractive investment options. Primarily because the yield they generated was higher than what they could earn on fixed deposits.

While all dividend payment announcements might have come with adequate disclosures, it led to complacency among investors regarding the risks involved mostly due to a lack of awareness.

In bull markets, investors didn't realize the impact of regular dividends on the Net Asset Value (NAV) of their scheme. But during bearish phases, they stared at losses on their invested capital.

Although they continued to receive dividends, the distributed amount eroded and what looked like a hot investment suddenly became an unprofitable proposition.

When they approached their distributors to check about losses at the NAV level, i.e. capital losses, mostly they were advised to consider adding dividend income to their total returns.

Oh! So wasn't dividend an income over and above capital gains? This was a shocker to many.

SEBI's circular referred to previously in this article is in response to such crafty practices of mutual fund houses and their distributors.

SEBI felt that mutual funds should clearly communicate that investors may receive a portion of their invested capital in the form of a dividend-realised undistributed profit maintained as equalisation reserve.

Table 2: How does going with the IDCW option impacts your returns?

  Investment date Amount invested (Rs) NAV at the time of
investment (Rs)
Subscription Units NAV as on record date
(17 May 2022)
Movement in NAV
from the date of
investment to the
record date
Dividend declared
(per unit)
Investor A 03-Aug-21 1,00,000 15 6,667 21 6 6
Investor B 03-Nov-21 1,00,000 18 5,556 21 3 6
Investor C 07-Feb-22 1,00,000 23 4,348 21 -2 6
For illustration purposes only

As you can see in Table 2, for investor 'A' there's no loss at the NAV level - i.e. in the principal. The entire dividend income has come from capital appreciation.

However, in the case of investor 'C', the dividend payment has resulted in capital withdrawal. While the impact on investor 'B' is a combination of both - Rs 3 per unit has been paid through appreciation and another Rs 3 by way of capital withdrawal.

This goes to show you can't always make quick gains by investing in a mutual fund scheme that is going to announce a dividend in the foreseeable future.

Should conservative investors and those depending on regular income choose the IDCW option?

Opting for IDCW can be quite detrimental to your long-term wealth creation since it hampers the process of power of compounding. IDCW is not good for pensioners and conservative investors either. IDCW can't be an alternative to interest-earning fixed-income investments.

And mind you, dividends aren't tax-free in the hands of investors anymore.

The government abolished Dividend Distribution Tax (DDT) from FY21. At present, all dividends paid by the mutual funds are added to one's total income and taxed at the applicable slab rates. Moreover, dividends in excess of Rs 5,000 attract a 10% TDS (Tax Deducted at Source).

If you are looking for a stable and regular income stream, choosing the IDCW option doesn't serve much of a purpose since the payment of dividends can be irregular. Nor will it help you save taxes.

Thus, at PersonalFN, we recommend our readers and investors to opt for Systematic Withdrawal Plans (SWPs) instead.

SWPs work on the same rupee-cost-averaging principle, just like SIPs (Systematic Investment Plans) do.

When you opt for SWPs, you instruct mutual funds to repurchase units worth the same amount every month from you, irrespective of market conditions. In turn, this eliminates the need to time the market to generate superior returns or earn a regular return.

Happy Investing!

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster.com. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.

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