When dividend rules hurt investors

Open-end mutual funds are gaining popularity in Bangladesh as retail investors look for diversification, liquidity and professional management. However, the current dividend and tax framework creates distortions, complicates fund operations, encourages inefficient investor behaviour, and ultimately undermines fairness, market efficiency and long-term investor confidence, although it was designed with good intentions.

An open-end mutual fund allows investors to buy and redeem units directly from the fund at its net asset value (NAV). Unlike closed-end funds, the number of units is not fixed and adjusts as investors enter or exit, providing built-in liquidity. Investors can convert their holdings into cash at any time by redeeming units at NAV.

Because of this feature, mandatory cash dividends are not economically essential for open-end funds. Redeeming units effectively serves the same purpose as receiving a dividend. When a fund distributes a dividend, its NAV falls by the same amount. No new wealth is created; value is simply converted into cash.

Take a simple example. An investor holds 1,000 units at Tk 10 each, worth Tk 10,000. If a 10 percent dividend is paid, the investor receives Tk 1,000 in cash, and the NAV falls to Tk 9. The total value remains Tk 10,000, only in a different form.

Despite this economic neutrality, Bangladesh’s regulatory and tax policies treat dividends and capital gains very differently. Mutual funds must distribute at least 70 percent of annual income as dividends, which are taxed at the investor’s personal rate, up to 30 percent. Capital gains receive more favourable treatment. Gains of up to Tk 50 lakh from mutual fund units are tax-exempt, while amounts above that are taxed at a flat 15 percent. Crucially, dividend tax applies even when the investor suffers an economic loss.

Consider an investor who buys 41,667 units at Tk 12 each on December 1, investing Tk 500,000. By December 31, the NAV falls to Tk 11.90, reducing the investment value to Tk 495,833. The fund then declares a Tk 1.50 dividend per unit, lowering the NAV to Tk 10.40. The dividend of Tk 62,500 is taxable. At 30 percent, the investor pays Tk 18,750 in tax, leaving a post-tax value of Tk 477,083. The investor incurs a net loss while still paying tax.

Faced with this mismatch, informed investors often redeem units just before the dividend record date, avoiding taxable dividends and converting returns into lightly taxed or exempt capital gains. While rational at an individual level, this behaviour creates systemic problems.

Pre-record-date redemptions force funds to sell assets, often at unfavourable prices, depressing NAV and harming long-term investors. Fewer outstanding units raise dividend amounts and tax burdens for those who remain, effectively transferring value to more tax-aware investors without improving fund performance. Fund managers are also distracted from long-term strategy as they manage liquidity, dividend timing and redemption risks.

The problem becomes more acute when asset management companies raise funds late in the year. With little time to deploy capital productively before dividend declarations, late investors may suffer capital losses yet still face dividend tax. Even when performance is reasonable, investors often feel cheated when taxed despite seeing no real gain. Trust in funds and in the industry erodes.

Asset managers face an uncomfortable choice: accept new inflows and risk harming investors, or refuse investments and constrain growth.

Two reforms could ease these distortions. First, regulators could introduce a capped tax exemption for mutual fund dividends, similar to the capital gains threshold. This would protect small, long-term investors and reduce tax-driven redemptions. Second, the requirement for mandatory dividend payouts in open-end funds should be reconsidered. Allowing earnings to remain invested and reflected in NAV would better align taxation with real wealth creation.

Bangladesh’s current framework, which mandates dividends while taxing them heavily and largely exempting capital gains, creates inefficient incentives and weakens investor confidence. Revisiting these rules is essential to build a fairer, more efficient and more resilient mutual fund industry.

The writer is director and chief strategy officer at Ekush Wealth Management Limited