With the Sensex at 30,000 points, the stock market and consequently mutual funds have started generating a lot of interest among retail investors. And not surprisingly so, as everyone wishes to taste a slice of the pie. That being said however, it has been our general observation (over the years) that investors tend to give a lot of time and importance to the process of selecting a mutual fund. However, once a particular fund is chosen, choosing the investment option – dividend or growth – is done on an almost arbitrary basis.

However, choosing the correct option is perhaps as important to the health of the investment as choosing the particular mutual fund is. What are the various factors one should consider and why is the subject matter of this article.

Background

There are two factors that are of prime importance when choosing the investment option — (A) Fiscal policy (B) Your investment needs and goals. Both these factors play an important role and let us see how we can tweak each for the maximum benefit.

Choosing the Dividend Option — Benefits and Drawbacks

Before considering the drawbacks, let us look at the benefit of choosing the Dividend option.

The foremost and the most obvious benefit is that the dividend is tax-free — in the real sense of the term. Though all MF dividends are tax-free, dividends received from non equity-oriented schemes are subject to distribution tax of 25%. Which means that though such dividend is tax-free in your hands, you are receiving 25% lesser than what you would have otherwise received. Which by inference means that it is you who is bearing the distribution tax, the MF only pays it on your behalf.

Dividends from equity schemes do not suffer this distribution tax and hence are truly tax-free. Then shouldn’t all investors choose the Dividend option? Isn’t this entire discussion a non-issue?

Not so fast. For which, let’s consider a live example — that of Birla Sun Life Equity Fund a scheme that has been in existence since 1998.

As on say 27th of April, the NAV of the growth option of this fund was Rs. 639.46 whereas that of the dividend option was Rs. 103.41. Why is this? The difference of Rs. 536.05 per unit is largely nothing but your own money paid back to you (by calling it dividend). The investor who has chosen not to receive the dividend is owed Rs. 639.46 per unit by the scheme whereas an investor choosing the dividend option is owed only Rs. 103.41.

It should be understood that dividend from a mutual fund, unlike stock dividend, is your own money coming back to you (this was discussed in the article published a few weeks ago) Therefore, had you invested in the Growth option of the scheme, the NAV of Rs. 639.46 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 Rs. 103.41.

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 or the IRR. But without going into the mathematical jargon, suffice it to say that the fund performance (which has been nothing less than spectacular) is based on the NAV of Rs. 639.46 and not Rs. 103.41.

So far so good. As long as you needed the dividend, all this really doesn’t matter. But our next question is what to do you do when the dividend comes and sits in your bank? Do you reinvest it in the same scheme or for that matter into another similar scheme? If so, do realise that you are reinvesting the money in the same asset class — Equity. It needn’t have come out of the asset class (in this case Birla Sun Life Equity) in the first place!

The second problem is agility. You may forget that the scheme has paid dividend and the money is lying in your bank. It happens. Or even if you are well aware of the fact, the market may be behaving whimsical and this volatility may delay your decision to enter. The money again sits in your bank.

All this time, when the money relaxes in your SB account, the rate of return of your investment is falling. The reason is simple arithmetic. The capital that is invested in the fund is growing at the IRR as discussed above (over 24% p.a. over 3 years and almost 25% p.a. since inception). However, the dividend that is lounging in the bank is growing at just 4-6% p.a. which is the SB interest rate (after deregulation). Over time, this substantial difference in the two rates dilutes the net return on the investment. More the time spent in the bank, more the dilution.

Other Reasons for choosing Dividend

Of course there are a couple of excellent reasons for choosing the dividend option. The first one is of course that you may need the funds for day to day 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 three years, by choosing the growth option you would be subjecting yourself to short-term capital gains tax. Short-term capital gains are to be added to your other income and taxed at the slab rate applicable to you.

Which means that if you fall in the highest tax bracket, you will end up paying 30% tax on the short-term gains. You would be much better off choosing the dividend option and bearing the distribution tax of 25%. This strategy is known as tax arbitrage.

A further refinement of the above strategy is to choose the Dividend Reinvestment option. This way, each dividend that is paid is allotted units and the dividend itself becomes the cost of such units. Ultimately, you will find that the short-term gains are further reduced on account of this notional cost.

To Sum

The psychology of investing, fiscal policy and your requirements from your investments, all go hand in hand in deciding the optimal option to choose from.

The authors may be contacted at wonderlandconsultants@yahoo.com

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