Equalisation reserve

When a new investor buys into an existing scheme, the price they pay is not purely the value of the underlying securities — part of it reflects realised gains the scheme has already banked. That component is credited to an equalisation reserve, and the scheme can later draw on it to help pay a distribution.

Why this matters to an investor: it means part of what shows up as a dividend is not really new investment income at all — some of it can be the investor's own capital being paid back to them through the distribution mechanism.

A certain proportion of the sale price of an investor's investment in a mutual fund scheme represents realised gains that are credited to an equalisation reserve. That reserve can be used to pay dividends.

Because of this, mutual funds are required to be transparent about what a distribution actually consists of: they must clearly indicate the distinction between how much of a distributable surplus paid out is the appreciation of NAV and how much is capital distribution. Investors need to be told, in other words, that their dividend also includes a certain part of their own capital rather than being entirely fresh investment gain.

An investor, Mr Rao, buys units of an existing debt scheme at a NAV that already reflects years of accumulated, realised gains the scheme has banked from earlier bond maturities and coupon receipts. Part of what he pays goes into the scheme's equalisation reserve.

Six months later the trustees declare an IDCW distribution of Rs 1.20 per unit. The scheme's disclosure breaks this down: Rs 0.70 is genuine appreciation earned since Mr Rao invested, and Rs 0.50 is capital distribution drawn from the equalisation reserve — effectively, part of his own money being returned to him rather than new income earned on his investment.

For Mr Rao, this matters beyond bookkeeping: a distribution that is substantially a return of his own capital is not the same economic event as a distribution that is substantially new investment gain, even though both arrive as the same rupee amount in his bank account.

Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units), in the discussion of dividend declaration procedure — record date, the public notice requirement, and the NAV decline on payout. Expect the equalisation reserve tested on what it represents (realised gains embedded in the sale price) and on the disclosure obligation it triggers (splitting a distribution into NAV appreciation versus capital distribution).

• The equalisation reserve is built from realised gains in the sale price paid by investors, not from unrealised, mark-to-market appreciation sitting in the portfolio.
• A dividend funded partly from the equalisation reserve is, economically, partly a return of capital — do not assume every rupee of a declared distribution is fresh investment income.
• Mutual funds must disclose the split between NAV appreciation and capital distribution within a payout — this is a stated disclosure obligation, not an optional courtesy.
• Do not confuse the equalisation reserve with an exit load or with the distributable reserves concept generally — the equalisation reserve is specifically the realised-gains component embedded in what a purchasing investor pays.