So, should you go for dividend option or growth?
Apart from taking a call on which mutual fund (MF) one should invest in, investors should give equal importance in chosing the investment option — dividend or growth — as it is equally important to the health and returns of the investment. What are the various factors one should consider and why is the subject matter of this article.
Two major factors that should be taken into consideration while choosing investment options are the fiscal policy and investor's requirements and goals. Let's see how we can tweak each for maximum benefit.
The dividend option: Benefits and drawbacks
Before considering the drawbacks, let us look at the benefits of the dividend option.
The most obvious benefit is that the dividend option is tax-free. Though all MF dividends are tax-free, dividends received from non equity-oriented schemes are subject to a distribution tax of 12.5%. Which means that you are receiving 12.5% lesser than what you would have otherwise received. So, you are bearing the 12.5% tax burden, the MF only pays it on your behalf.
Dividends from equity schemes do not suffer this distribution tax and hence are truly tax-free. Going by that logic, shouldn't all investors choose the dividend option? Isn't this entire discussion a non-issue?
Not so fast. Let's consider a live example — that of HDFC Equity Fund, a scheme that has been in existence since December 1994.
As on say November 15, the (net asset value) NAV of the growth option of the fund was `240.63, whereas that of the dividend option was `40.65. The difference of `199.98 per unit is nothing but your own money paid to you by calling it dividend. The investor who has chosen not to receive dividend is owed `240.63 per unit by the scheme, whereas an investor choosing the dividend option is owed only `40.65.
It should be understood that dividend from a mutual fund, unlike stock dividend, is your own money coming back to you. Therefore, had you invested in the growth option of the scheme, the NAV of `240.63 would apply to you. But since you have chosen the dividend option, periodically, some of your invested amount was paid back to you (by calling it dividend) and hence the market value of your units is `40.65.
Now, also note that the scheme performance is calculated based on the growth option NAV. Actually, technically, it doesn't matter which NAV is chosen, as the dividends received are assumed to have been reinvested in the scheme at the Internal Rate of Return (IRR).
But without going into the mathematical jargon, it is enough to say that the fund performance (which has been nothing less than spectacular) is based on the NAV of `240.63 and not `40.65. So far, so good. As long as you need the dividend, this really doesn't matter.
But my next question is, what do you do after the dividend comes in? Do you reinvest it in the same scheme or another similar one? If you do that, do realise that you are reinvesting the money in the same asset class — equity. The second problem is agility. Dividend from the scheme is lying in your bank. Also,the market is volatile and delaying your decision to enter. So, the money sits in your bank.
All this time, when the money is in your savings bank (SB) account, the rate of return of your investment is falling.
The reason is simple. The capital that is invested in the fund is growing at the IRR as discussed above (around 19% over three years and almost 20% since inception). However, the dividend that is lounging in the bank is growing at just 4-6% per annum which is the savings bank interest rate (after deregulation). Over time, this substantial difference in the two rates dilutes the net return on the investment. More the more time spent in the bank, more would be the dilution.
Other reasons to chose dividend
Of course, there are a couple of excellent reasons for choosing the dividend option. The first one is that you may need the funds for everyday life. The second one is that getting dividend in a rising market is like partial profit -booking. The funds representing dividend can be invested into fixed income avenues, thereby rebalancing the asset allocation.
Or take the case of debt funds. If your investment time-frame is less than a year, by choosing the growth option, you would be subjecting yourself to short-term capital gains tax. Short-term capital gains are to be clubbed with your other income and taxed at the slab rate applicable to you. So, if you fall in the highest tax bracket, you pay 30% tax on short-term gains. You would be much better off choosing the dividend option and bearing the distribution tax of 12.5%. This strategy is known as tax arbitrage.
A further refinement of the above strategy is to choose the dividend reinvestment option. This way, every dividend that is paid is allotted units and the dividend itself becomes the cost of such units. Ultimately, you will find that short-term gains are further reduced on account of this notional cost.
To sum it up
The psychology of investing, fiscal policy and your requirements deciding the optimal option to choose.
Apart from taking a call on which mutual fund (MF) one should invest in, investors should give equal importance in chosing the investment option — dividend or growth — as it is equally important to the health and returns of the investment. What are the various factors one should consider and why is the subject matter of this article.
Two major factors that should be taken into consideration while choosing investment options are the fiscal policy and investor's requirements and goals. Let's see how we can tweak each for maximum benefit.
The dividend option: Benefits and drawbacks
Before considering the drawbacks, let us look at the benefits of the dividend option.
The most obvious benefit is that the dividend option is tax-free. Though all MF dividends are tax-free, dividends received from non equity-oriented schemes are subject to a distribution tax of 12.5%. Which means that you are receiving 12.5% lesser than what you would have otherwise received. So, you are bearing the 12.5% tax burden, the MF only pays it on your behalf.
Dividends from equity schemes do not suffer this distribution tax and hence are truly tax-free. Going by that logic, shouldn't all investors choose the dividend option? Isn't this entire discussion a non-issue?
Not so fast. Let's consider a live example — that of HDFC Equity Fund, a scheme that has been in existence since December 1994.
As on say November 15, the (net asset value) NAV of the growth option of the fund was `240.63, whereas that of the dividend option was `40.65. The difference of `199.98 per unit is nothing but your own money paid to you by calling it dividend. The investor who has chosen not to receive dividend is owed `240.63 per unit by the scheme, whereas an investor choosing the dividend option is owed only `40.65.
It should be understood that dividend from a mutual fund, unlike stock dividend, is your own money coming back to you. Therefore, had you invested in the growth option of the scheme, the NAV of `240.63 would apply to you. But since you have chosen the dividend option, periodically, some of your invested amount was paid back to you (by calling it dividend) and hence the market value of your units is `40.65.
Now, also note that the scheme performance is calculated based on the growth option NAV. Actually, technically, it doesn't matter which NAV is chosen, as the dividends received are assumed to have been reinvested in the scheme at the Internal Rate of Return (IRR).
But without going into the mathematical jargon, it is enough to say that the fund performance (which has been nothing less than spectacular) is based on the NAV of `240.63 and not `40.65. So far, so good. As long as you need the dividend, this really doesn't matter.
But my next question is, what do you do after the dividend comes in? Do you reinvest it in the same scheme or another similar one? If you do that, do realise that you are reinvesting the money in the same asset class — equity. The second problem is agility. Dividend from the scheme is lying in your bank. Also,the market is volatile and delaying your decision to enter. So, the money sits in your bank.
All this time, when the money is in your savings bank (SB) account, the rate of return of your investment is falling.
The reason is simple. The capital that is invested in the fund is growing at the IRR as discussed above (around 19% over three years and almost 20% since inception). However, the dividend that is lounging in the bank is growing at just 4-6% per annum which is the savings bank interest rate (after deregulation). Over time, this substantial difference in the two rates dilutes the net return on the investment. More the more time spent in the bank, more would be the dilution.
Other reasons to chose dividend
Of course, there are a couple of excellent reasons for choosing the dividend option. The first one is that you may need the funds for everyday life. The second one is that getting dividend in a rising market is like partial profit -booking. The funds representing dividend can be invested into fixed income avenues, thereby rebalancing the asset allocation.
Or take the case of debt funds. If your investment time-frame is less than a year, by choosing the growth option, you would be subjecting yourself to short-term capital gains tax. Short-term capital gains are to be clubbed with your other income and taxed at the slab rate applicable to you. So, if you fall in the highest tax bracket, you pay 30% tax on short-term gains. You would be much better off choosing the dividend option and bearing the distribution tax of 12.5%. This strategy is known as tax arbitrage.
A further refinement of the above strategy is to choose the dividend reinvestment option. This way, every dividend that is paid is allotted units and the dividend itself becomes the cost of such units. Ultimately, you will find that short-term gains are further reduced on account of this notional cost.
To sum it up
The psychology of investing, fiscal policy and your requirements deciding the optimal option to choose.
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