How Mutual Funds Pay Dividends

Overview of Mutual Funds

A mutual fund is a professionally managed investment fund which pools in money which is accumulated from various investors in order to invest in securities such as bonds, stocks, money market instruments, and additional assets. Professional portfolio managers operate mutual funds and they invest the money in a diversified portfolio in order to minimise the risks and optimize the percentage of returns.

Types of mutual funds

There are many types of mutual funds which are open for subscription by investors such as Money market funds, Fixed income funds, Equity funds, Balanced funds, Index funds, Specialty funds, Fund-of-funds.

Out of these funds, the Equity Funds are those fund which mainly invests in stocks. This type of fund aims to grow the value of the portfolio faster but usually are subject to higher risks than others for example a money market or fixed income fund, which aims to provide stable returns to the investors. However, an income fund can be a type of equity fund which invests in dividend-oriented stocks providing significant amount of current income in the form of dividends and can be considered to play the role of a dividend mutual fund.

Dividend mutual funds are that stock mutual funds which mainly invest in those stocks that distribute dividends, which are a share of profits that companies distribute to investors. The dividend can be utilised to purchase more units of the mutual fund as well as it can be received as a source of cash. Many investors who purchase dividend mutual funds are mainly exploring ways to earn an income. Due to their characteristic of income-generation, dividend mutual funds are better suited for those investors who do not have a recurring income. It is less risky as compared to other types of mutual funds, such as growth-oriented mutual funds.

The various ways of Dividend payments

Accumulation and Timing – The companies which provide dividends on common stock or preferred stock or combination of both, generally pay on three-month basis (i.e. quarterly). However, some of the dividend-paying companies distribute dividends on a semi-annual basis. The focus of such mutual funds is to accumulate the profit or dividend earned from the companies and then pay to the investors on a pro-rata basis, according to the ratio of their contributions.

The dividend legally needs to be distributed once in a year, and those dividends which are geared towards providing investors with current income will pay dividends on a monthly or quarterly basis. But various funds provide dividends on a semi-annual basis or annual basis due to a reduction in administrative expenses.

Some funds hold back certain dividends for a few months and then pay out the same in subsequent months for achieving a further balanced circulation of income to investors.

Dividend Reinvestment - The investors who are not yet retired are generally inclined to reinvest their dividends rather than accept a pay-out. Moreover, creating a dividend reinvestment strategy is easy to implement with mutual funds. The shareholders give permission to fund companies or brokers to reinvest the cash automatically to purchase extra shares.

Investors can utilize their dividends to buy shares of another mutual fund, but the second fund should be within its own family of funds with respect to the investment objective. Then only the first fund will generally allow this. Investment firms and private brokers frequently carry this out, irrespective of what type of fund is being bought.Â

Share Pricing and Tax Exposure – The funds that provide dividends will result in decline of their unit price due to payment of dividend on the ex-dividend date in a similar way as individual stocks. For Instance, a fund with a share price of £10.42 that pays a dividend of £0.10 per share will trade at £10.32 on the ex-dividend date.

Until the funds come from a tax-advantaged retirement plans or an individual retirement accounts, entire dividends are considered as ordinary income in that year in which they are distributed.

Consideration of Interest payments – These mutual funds may have portfolios which comprise of dividend-oriented stocks or interest-bearing fixed income instruments or a combination of both. The net income to investors through dividend distribution comprises of interest from debt securities, for example- government bonds, Treasury notes and corporate bonds.

A bond usually pays a fixed rate of interest every year, which is called coupon payment. The payment is made on the face value of the bonds as a percentage. In contrary to stock dividends, interest on a bond is certain.

Types of Mutual Funds which pay the higher dividends

Dividend Stock Funds – Dividend stock funds could be the best platform for those investors who are willing to receive regular dividend income and who take some amount of risk for a shot at capital gains. These funds mainly focus on those stocks, which have an excellent track record of paying considerable dividend every year. However, paying a dividend is a good sign for the company’s health, which shows that the company is financially stable; many such companies feel that it is an honour to issue growing dividends every year.

The dividend mutual are not geared to focus on capital gains. Still, large and stable companies distribute substantial dividends which help their stocks to trend upwards over time and increase the value of the fund.

Dividend bonds Funds – Unlike stock funds, the distributions of the bond fund are impacted by various factors which include national interest rates at the time of issuance and the credit rating of the bond-issuing entity. The dividend distributions are reflections of interest received by the bond fund from the respective issuers, which are added to the fund’s portfolio.

High-yield dividend funds invest in low credit rated bons, also known as junk bonds which pay high rates of interest in order to reward investors for the expanded risk of default by financially unstable issuing entities. By investing in these types of funds, the dividend income can be significant although it comes at tremendous risk.

High-yielding dividend stocks to watch for in the United Kingdom

Micro Focus International Plc (LON:MCRO) – Microfocus international Plc is the international IT and software company which provided 8.6 per cent of yield of dividend and which was ahead of others in the year 2019.

Rio Tinto Plc (LON:RIO)  – Rio Tinto Plc is the third-biggest mining company in the world and has provided 8.3 per cent of dividend yield in the year 2019 because Rio Tinto’s profits have moved up by an average of 32 per cent every year for the last five years.

Aviva Plc (LON: AV.)  - Aviva was established in the year 2000 through a merger of two United Kingdom’s insurance firms. Aviva provided 7.2 per cent of dividend yield in the year 2019 because it maintained very good pay-out from many years on assurance of its booming cash flows.