Dividend or growth - which option is better for a mutual fund investor?

My article in Mumbai edition of Mid-day Gujarati today (page 15, bottom half)

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The English translation of the same is as under:

Mutual funds are supposed to simplify our lives. However, with more and more attempts at simplifying, the industry has increased the options and the choices for the investors. The number of choices now has reached intimidating proportions.

Let us demystify various dividend options. This should help us take better decisions and make the decision making process easier. We will discuss the objective behind the options and how these can be effectively used in order to achieve our goals.

In the parlance of mutual funds, dividend is distribution of income earned by the mutual fund portfolio. The fund’s money is invested in various securities – these securities generate returns in form of capital gains (difference between sale price and purchase price), interest (debt or money market securities), or dividend (in case of equity securities or other mutual fund schemes). Such returns, if retained in the mutual fund will result into increase in the NAV per unit. Part of these returns can be distributed to the fund’s investors. This distribution is called dividend.

Broadly, an investor can opt for either a dividend or a growth option. Then, within the dividend option, there are choices like the periodicity (in certain cases – especially the debt and liquid funds) of dividend and whether one wants to receive the dividend in hands or get the same reinvested. Reinvestment of dividend results in purchase of more units of the same fund.

The entire hierarchy is given below for a quick reference.

One must note that the dividend frequency options are not available across all types of funds or all schemes. A fixed frequency is not available in case of equity and balanced funds. The daily or weekly options are available only in case of liquid category of funds. Most of the times, there is no payout option in case of daily or weekly frequency and the dividend is compulsorily reinvested.

Which option should an investor opt for? Why?

The answer starts from the objective of the investor. For what purpose was the investment done? What is the goal that the investor wants to achieve through the said investment? Broadly, investors invest their money with one of the three purposes: viz. accumulation, regular income or temporary parking of surplus funds.

Among these three, what one should do with the dividends – whether to take payout or reinvest the dividend – seems quite obvious. Growth option seems logical for accumulation goal and dividend payout for regular income goal. If only life was so simple.

An important factor to consider is the tax treatment of the income as well as the tax status of the investor. Dividends from mutual funds are tax-free in the hands of the investor. However, in case of funds classified as non-equity funds, there is a dividend distribution tax charged on the quantum of dividend distributed to the investors. This tax is charged before the fund pays out the dividend to the investor.

On the other hand, if an investor has opted for growth option, the difference between sale price and purchase price would be considered capital gains. In case of equity oriented funds, gains booked after completion of 1 year from the date of investment are long term whereas those booked before completing one year are short term. (This period is three years in case of all non-equity oriented funds). The short term gains are added to the person’s income for the respective year and taxed at the marginal rate of tax applicable to the assessee for the year.

As can be seen from the above, the tax is likely to be higher on short term capital gains for an investor in a higher income slab. On the other hand, if an investor is in the tax-exempt category or one who does not have a source of income or where the income is below the taxable limits, it would be unwise to opt for dividend option even if there is a need to get regular income. The dividend distribution tax is applicable to all investors irrespective of the level of income.

The last two paragraphs are applicable more to debt and liquid funds than to equity funds. In case of equity funds, many investors perceive that dividend option is better than growth. The logic here is that the dividends are paid out when the fund has made profit. The sad reality is that the dividends may or may not be paid out in boom times when the fund is supposed to have made profits. Many investors expect the fund managers to be able to predict the market tops and thus payout dividends. Once again, the sad reality is that the history does not offer any evidence to the effect. It may be prudent to opt for growth option in equity funds if the time horizon is long, say 10 year or more. The growth option will allow the investor to benefit from the power of compounding.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions. He can be reached at amit@karmayog-knowledge.com