For mutual fund investors, one good thing that emerged from the Union Budget 2003 was tax-free dividends. Of course, a 'booming' equity market helped the investor's (and the fund's) cause even further. Funds have gone right ahead and have passed on the benefit to the investor in the form of dividends. Some funds have even declared multiple dividends within the same scheme. So why is that such a bad thing?

Declaring dividends per se, is not a bad thing. It's certainly helps the investor as he can capture the growth in his mutual fund investment, in which case even if the markets turn, he would have made a return. So dividends are fine and funds are doing just what investors want. However, when you have a dividend declaration every other month from the same fund house, that's not necessarily something that benefits the investing community at large. Lets understand why.

First lets discuss why an equity fund would need to declare dividends so frequently. From the fund's perspective, declaring dividends at frequent intervals gives it an investor-friendly reputation. An equally great thing for the fund is that it gets 'fresh investors' who were unfortunate to miss the dividend declared the last time around, which could be a month back. And while investors are busy collecting their dividends, the fund has slowly but surely built a history of about half a dozen dividends in just a year's time! This will certainly come handy in the years to come to underline the fund's credentials as a well-managed, pro-investor, fund house.

From the investor's perspective -- is a fund that declares dividends ever so often necessarily a well-managed, pro-investor fund house? Investors need to first question the rationale behind declaring dividends so frequently. Why can't a fund declare dividends just once after building up sufficient reserve? Instead of paying 50 per cent across say 5 months, why can't the fund pay 50 per cent once at the end of 5 months?

Is there anything to suggest that a fund that does the latter is not well-managed and pro-investor as much as the fund that has resorted to the former? Investors need to ask themselves whether they are investing in an equity/balanced fund because of the dividend declaration or because the fund is well-managed? Remember both these yardsticks do not necessarily coincide -- as we said earlier, its the equity market boom that is fuelling dividends, not smart fund management. So do dividends distort the picture for the investor?

Another very pertinent question that investors need to ask, especially ELSS (tax-saving funds) investors is why haven't funds shown the same kind of enthusiasm and pro-investor attitude in declaring frequent dividends in their ELSS, as much as their equity and balanced funds.

Logically, shouldn't an ELSS investor have as much right in benefiting from booming equity markets as much as his equity/balanced fund counterpart? In fact, the ELSS investor could use a dividend more than the others. This is because he may well have to confront a scenario on his exit when the markets have corrected at a lower level, after having appreciated sharply in the interim period, while he was unable to benefit from it because of the 3-Yr lock-in.

What must have been equally distressing for him is to see investors in equity funds around him collect dividends left, right and centre, while remaining invested only for about 12 months! That's a huge price to pay for being a long-term investor! Maybe funds shouldn't just wish that investors take a long term perspective and actually do something to enable investors to do that - rewarding them (and not the short-term, opportunistic investors) with dividends could be one way.

Already the mutual fund industry has been ticked off by Securities and Exchange Board of India and Association of Mutual Funds in India  for overdoing the dividend declarations and encouraging investors to strip dividends. It should surprise no one if dividends get taxed next year if the tax exemption is not taken in the right spirit by mutual funds and the high networth investor. If dividends do get taxed, then it could well be another instance of the high networth individual playing spoilsport for the retail investor.

Right now the global mutual fund industry is at the crossroad and being asked to 'show-cause' why the retail investor must repose confidence and continue to invest in it.

At a time like this, the domestic mutual fund industry must try to ensure that the malaise caused by greed to mobilise assets remains very much an American concept. As far as the retail investor is concerned, he needs to remain focused on his objective, which ideally should be long-term investing and look for funds with a good, solid track record and not necessarily a great dividend history.