Do interest paying funds affect your capital?

If I invest Rs 10 lakh in HDFC Balanced Advantage Fund, it is giving me monthly interest. Is this reducing my capital base or will the capital also appreciate? - Anonymous

You are most likely referring to the income distribution cum capital withdrawal (IDCW) plan of the fund which was earlier named (misleadingly though) as dividend plans. The revised nomenclature now accurately refers to what happens to your investment in such plans - they pay you a certain sum of money (which you referred to as "interest") from your own deployed capital plus whatever appreciation or depreciation it may have had as per the fund's performance.

Here's how it works
For example, if you invest Rs 10,00,000 in an IDCW fund plan with a net asset value (NAV) of Rs 100 per unit, you own 10,000 units of the fund. When the fund announces a payout of 5 per cent, which is a payment of Rs 5 per unit, you will receive Rs 50,000 for your 10,000 units. However, this payment will reduce the value of your capital base by this Rs 50,000 whereby the NAV of the fund will drop by Rs 5 per unit on the payout record date, making it Rs 95.

So yes, "interest" giving funds do reduce your capital base.

There are good reasons why one should avoid IDCW fund plans:

• It is the AMC, and not you, that determines the timing and amount of the payout you receive. It reduces the fund's NAV, and thus your invested capital, accordingly.
• It also affects the compounding potential of your investment as it is reduced by the payouts over time - those payouts which may or may not necessarily be what you require.
• Further, the payouts received by you are subject to income tax. The entire payout money is taxed at the applicable tax slab in your case. This is likely to be more than the tax on the money you withdraw from the fund yourself. This is because the latter option is likely to be more tax efficient (given the current taxation rules) as only the appreciation from the redemption amount is taxed as capital gains.

In most cases, we always suggest investing in growth plans over IDCW mutual fund plans. Additionally, if regular income is what you need, then you may need to revisit your investing decision of investing in an IDCW plan. That is because investing in a growth plan and withdrawing from it through a systematic withdrawal plan (SWP) as per your specific needs would most likely be a better option.

In case one has already invested in an IDCW plan and wishes to make the switch to a growth plan, then they need to be mindful of the associated cost implications, such as the capital gains tax and exit load applicable on redeeming the former.