Mutual Funds - Your Money: Calculating returns on dividend reinvestment MF schemes

Assuming that the investment into a mutual fund is made on April 1 of a year, the return for the period from that day till the end of March of the following year, maybe computed as follows.

People typically invest in mutual funds on many occasions during the year, and also make withdrawals on multiple occasions. Mutual funds periodically pay dividends. If the investor has chosen the growth option there will be no periodic cash receipts. The same is true if he has chosen the dividend reinvestment option. In the second case, however, unit holding will steadily increase. However, if he has opted for the dividend option, he will receive periodic payouts. In practice, an investor is likely to withdraw a few payouts in the form of cash, and reinvest others in the fund. In the second case, there will be no cash inflows from the investment, but the number of units held will increase. This will have consequences when future dividends are declared.

Cash flow
Assuming that the investment into a mutual fund is made on April 1 of a year, the return for the period from that day till the end of March of the following year, may be computed as follows. The initial investment will be shown as a negative cash flow. As far as subsequent dividends are concerned, those which are taken in the form of cash will manifest themselves as cash inflows, and will consequently have a positive sign.

Dividends which are reinvested, have implications for the total units held, and consequently for future cash inflows from dividends. In practice, investors will invest multiple times during the course of the year, as well as redeem units on multiple occasions. Every investment should be treated as a negative cash flow, and every redemption, as a positive cash flow.

Internal Rate of Return
One way to estimate the return from the portfolio is to compute the Internal Rate of Return or the IRR. The IRR formula assumes that the time interval between successive payments is constant. This is unlikely to be the case for mutual fund investments, since both investments as well as redemptions, may be made at any point during the course of the payment. For this kind of a situation, Excel provides the XIRR function, which allows for the time span between successive cash flows to be variable.

In the case of our mutual fund portfolio, if we project monthly cash flows, we will get a monthly rate of return. This can be converted into Bond Equivalent Yield to facilitate comparisons with coupon paying debt securities, which in practice are an investment alternative. Most bonds pay coupons semi-annually. Consequently, to compute the bond equivalent yield of an investment that yields monthly cash flows, the practice is to add one to the monthly IRR, raise that to the power of six, and then subtract one. The answer is then multiplied by two to annualise it.

While projecting cash flows for a mutual fund investment, care should be taken from the standpoint of factoring in loads. If there is an entry load, the number of units received will be less for a given investment. The same holds true for subsequent investments.

If there is an exit load then the amount realised from redemption will be less for a given number of units. The consequences of tax laws should also be borne in mind. Depending on the laws prevailing at a point in time, there could be tax implications for both dividends and capital gains. The rate of tax could also depend on the amount of time for which the units have been held.

Source : Financial Express back