Hybrid Dividends? In Mutual Funds?

Hybrid Dividends? In Mutual Funds?

Ganga Prasad Rao
gangaprasad.rao@gmail.com
http://myprofile.cos.com/gangar



SEBI recently came out with a ruling that mutual funds may only distribute the 'surplus' appreciation over an arbitrarily-defined benchmark NAV - the NAV of the previous dividend declaration. This has been widely hailed as a financially prudent step in the 'left' direction. It limits the practice of mutual funds garnering fresh subscriptions by declaring large dividends that eat in to the NAV and the networth of existing investors. But it is also a 'retrograde' policy that steps on the toes of the fund managers' freedom who are limited in their decisions concerning the timing and quantum of dividends. The policy also punishes the small investor in funds that declare small dividends just ahead of a big market crash. With another market crash in the offing (hopefully not!), and with the coffers of the 'Investor Education and Protection Fund' overflowing, ain't it the right time to consider, even propose, an alternative?

The proposal is not unlike an inverse-analog of the 'auto-pay' option offered at select fund houses. Under the 'auto-pay' the NAV of the mutual fund holds but the number of units is reduced to issue the dividend; the proposed dividend payout-variant holds the number of units constant, but varies the NAV to accommodate individual dividend needs. The proposal is implemented by conceptualizing a 'hybrid' structure for a mutual fund - a fund that is both open and closed. Open in the sense that investors may make fresh purchases, and closed in the sense that investors may not redeem units. Instead, investors elect to receive differential dividend payouts. The trick behind 'differential dividend payouts' is to declare a 'base rate' of dividend applicable to all investors invested in the 'dividend payout' option, and then permit every investor in the 'differential-payout' option to receive dividend at some multiple or fraction of the declared base rate. Each investor in the payout option will have the right to periodically re-set his dividend 'beta' (the update taking effect a week later/month-end to preclude dividend anticipation, though and given the intent of the proposal, one could argue against such limitation. The fund house would also place restrictions on the number of switches permitted in a year and the minimum balance to be maintained, but those issues have ready solutions.). Since investors differ with respect to their risk-apetite and their view of the market, the mechanism to set a investor-specific dividend-payout rate facilitates participatory-, risk-based decision-making by individual investors that is lacking in the mutual fund market. Fund managers may breathe a tad easier with their decisions concerning the timing and quantum of dividends, comforted by the knowledge investors now have an option to tune their dividend-payout 'betas' to personal preferences, risk-apetite and view of the market.

An illustration would be useful. Assume two investors - one with a higher risk apetite and a long-view of the market, and the other - either a resource-constrained investor and/or with a lower risk-apetite and/or a short-view of the market, invest 1000 units in a Mutual Fund IPO issued at Rs 10 in the dividend payout option. Investor A opts for a dividend payout at half the 'base rate' declared by the fund, while Investor B opts to receive dividend at twice the base rate. When the fund house declares a dividend of Rs 2 on the fund's NAV appreciating to Rs 15, Investor A receives Rs 1000 as his dividend, and Investor B, Rs 4000. The NAVs for the two individuals diverge from that point from Rs 13, the 'benchmark' NAV for the fund. One could fault the proposal for the incremental cost of computing a investor-specific NAVs and dividend payouts, but in these days of gazillion-Hz supercomputing and FIIs and fund houses profiting from every paise of arbitrage, computing investor-specific NAVs - as is prevalent in retirement basket investments - is no hassle at all.

There are definite efficiency advantages to this system. The fund could be closed for the long term - a decade or more, permitting it to be positioned as an 'endowment' or 'lifetime' fund, and thus garnering a share of the inter-generational wealth-planning market. The freedom to vary one's 'payout-beta' even while permitting the fund manager to decide the timing of the dividend declaration is a strategy that optimizes individual preferences with 'group-decisions' (since the fund manager is better-informed, 'better-positioned, and invests for the group). Further, and since investors may change their personal dividend-payout 'beta', the hybrid scheme permits, on one hand, the 'resource-constrained' investor, and on the other, the wealthy and more aware investor to exploit the fund manager's wisdom to one's advantage without playing the 'invest and redeem' cycle - a strategy that has been the downfall of many small investors. The former appreciates the freedom to take a large lump-sum dividend in a year of his or her need by increasing the 'payout-beta', even while the latter - a higher-risk apetite, long-investor - 'goes against the grain' and chooses to bank rather than bleed his dividends in an 'up' year.

This brings us to the question of the investor-composition of these funds and how it affects the fund manager's dividend declarations. Is the fund manager more answerable to the mass of small investors who constitute 95% of the fund members, or to the handful of large investors who constitute 50% or more of the fund's assets? If the former, the manager is likely to declare frequent, if small dividends. If latter, the dividends are likely to be infrequent and strategic (as at the verge of the end of a long bull-run). Now, there are those other issues, notably the tax treatment of 'hybrid dividends' when an individual's dividend erodes in to his invested capital. Also, and truth be said, large investors, with the 'inside' on the stock market, are likely to exploit the features of this scheme to their advantage, but that is as much a problem with the existing system.

A little bit of extra 'wiggle-room' for the fund manager and the hapless small investor won't do any harm to the market, would it? I don't think so. Whatchabouju?