How Are Dividends Calculated on Mutual Funds?

by Wilhelm Schnotz, studioD

Investing in a mutual fund is similar to purchasing stock from a corporation. When you purchase a share of stock, you own a portion of its assets, such as real estate and machinery, and if it posts a profit, you receive a dividend based on your level of investment. Loosely think of a mutual fund as a company that engages only in trading, and a share in it purchases a proportionate amount of each of its stocks. When those stocks pay dividends, funds share these proceeds proportionately with shareholders.

Types of Mutual Funds

Although any type of mutual fund may receive dividends from its holdings, only funds classified as income funds actively seek to hold stocks that pay dividends. Because of the focus on dividends, the value of each share, called its net asset value (NAV), may not increase dramatically, but shareholders can expect steady dividend payments. Investors manage growth funds with the opposite goal, purchasing funds that are expected to increase in value without paying dividends. Growth funds’ yield stems from capital gains – sales of stocks for a profit – or through an increased NAV.

Calculating Distributions

Money received from a mutual fund is often known as a distribution as well as a dividend, and both growth and income funds calculate distributions using the same method. Managers total all profits from a reporting period, be they dividends or capital gains, on the fund’s record date, subtract operating costs such as fees, and divide the remaining amount by the total number of shares in the fund. Each investor then receives a distribution per share of the fund he owns. Thus, an investor with 100 shares in a fund that provides a $5 distribution per share receives $500. Some funds may reinvest a portion of dividends and gains to increase each share’s NAV, increasing the value of the fund.

Representing Dividend Values

Because mutual funds don’t report distributions of dividends and gains directly attributable to their NAV, rates of return can be misleading to novice investors. Mutual funds report their distributions as a percentage of a $10 benchmark, not as a percentage of their NAV. Because of this, a fund with a $250 share price that reports an 80 percent distribution doesn’t pay a $200 distribution, and instead provided investors $8, or 80 percent of $10, on its report date.

Timing Mutual Fund Purchases

Mutual funds typically pass distributions on to shareholders to avoid taxation, which shifts the tax burden to shareholders for their portion of profits. When funds pay distributions, their NAV adjusts accordingly – a share price falls $5 after a $5 per share distribution – and individual investors are taxed on the distribution amount. Investors who purchase funds right before the report date receive the distribution, which is taxable, and their investment’s value decreases. Instead of essentially receiving a taxable refund on the price by purchasing funds close to the report date, investors who wait until after the fund calculates distributions to purchase avoid unnecessary taxes.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.

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