Before we discuss about dividend in ETFs and Index Funds, please note dividends in any Mutual Fund scheme is just feel good factor and not similar to dividends received from stocks. Its investors own money which is paid out to them for making them happy. One should invest in equity fund for growth and not for dividends.
As ETFs and Index Funds are gaining popularity in India, more and more people are curious to know how exactly they operate. Dividends from ETFs, Index Funds and in general Mutual Funds is one of that curiosity. Let us understand, role dividends play in ETFs and Index Funds.
An ETF or Index Fund invest in a particular index on investor’s behalf. So if you invest Rs. 1,000 in any ETF or Index Fund, a fund manager will buy securities/stocks forming part of an Index and in same proportion. For example, if XYZ stock is 10% of the index, Rs. 100 out of Rs. 1,000 will be invested in stock XYZ.
Now if this company pay any dividends, ETF or Index Fund will get its benefit. The scheme will keep accumulating this dividends and will reinvest in to index whenever possible.
Let us understand this with an example. Suppose the NAV of an ETF or Index Fund is Rs. 1,000 on January 1, 2018 and index is at 10,000 point. Suppose on April 1, 2018 scheme gets Rs. 10, on June 1, 2018 Rs. 20 and on August 1, 2018 Rs. 5 as dividends. Now on March 31, 2018 if index grows to 20,000 point ideally NAV of the scheme should grow to Rs. 2,000. But as scheme have got dividend of Rs. 35 during the year, NAV will grow to Rs. 2,035.
Period and amount mentioned in above example is just for the simplicity. In reality, fund manager keep on watching cash levels of funds and other corporate announcements of underlying stocks and accordingly decide to reinvest accumulated dividends in such way that it do not cause for high tracking error.
Up to this point, investors are benefited by way of appreciation in NAV of an ETF & Index Fund.
There are few ETFs and Index Funds which payout portion of this dividends to their investors. Accordingly NAV of the ETF and Index Fund will reduce.