Choosing Growth Or Dividend Option

One of the most frequently asked questions by our investors, especially when markets touch all-time highs like today on November 12^th, 2014 when S&P BSE Sensex closed above the 28,000 mark*, is about the choice between Growth and Dividend option in mutual funds. Many also write to us wondering why our funds don't declare dividends despite their performance. Let's look at these issues in this article.

Dividend, as most of you know, is the portion of profits that a company pays its shareholders. In a mutual fund dividend is paid to investors from the returns it makes on the portfolio. Growth option and dividend option in mutual funds
Mutual fund schemes offer 2 options to investors – growth or dividend. Yet declaring dividends is at the fund’s discretion. Investors who go for the growth option do not receive any interim payouts from the scheme. When they redeem their holding they get capital appreciation, which is the growth in their invested capital. This is from the accumulated returns of the fund. Whereas investors choosing the dividend option expect to receive payouts, subject to dividend distribution tax, from time to time, of the returns the scheme makes. Their invested capital does not appreciate as much as the appreciation in the fund’s portfolio is paid out as dividends. Thus the portfolios, % return in both options remain the same although the NAVs would differ.

Dividend option is further classified as 2 - dividend payout or dividend reinvestment. Like the names suggest, dividend is paid to the investor’s bank account in the former. In the latter it is reinvested in the fund and the investor gets additional units of the fund.

Now the question at hand is which of these is better for an investor; growth option or dividend option? Let’s consider another question to answer that.

Why would investors choose the dividend option?

There could be 2 reasons why investors might go for the dividend option instead of the growth option –
i. Tax considerations
ii. They require regular streams of income from their investment
Sometimes the only reason why investors go for the dividend option is from the taxation perspective. Dividends may be taxed favorably than capital gains in certain investments. However this is not true in case of equity investments where long term capital gains are nil. Here investors, instead of letting investments compound would end up spending them.

There may be investors who are dependent on returns from their investments for regular income or maybe a part of their income. They may go for dividends. But are dividends are the best solution? We know that the amount of dividends is never fixed nor is the frequency. What if, say, the dividends paid out in a certain month are less than what you need? Or what if in a certain month you get more dividends than you require? You might have liked to let it compound than spend it on something you don’t really need. And by the time you figure out you want to invest the rest again you’d face “reinvestment risk”, that is the investment opportunity could have vanished and the investor may have to pay transaction charges. So dividends are not a good way out.

Instead you can declare your own dividend!

You have a another way of paying yourself the exact amount of income you require from your investments, without opting for dividends. It’s called an SWP or Systematic Withdrawal Plan. This facility allows you to redeem specified amounts from your fund at a pre-defined frequency. You can choose to regularly withdraw either a fixed sum or even just the appreciation on your investment, which will not disturb your capital investment.

Apart from not being an efficient method of getting regular income, dividends have another major drawback. For regular dividends to be paid out, a certain number of holdings must be sold off in order to raise the money. Now this sell off might not be at the most appropriate timing, or rather might not be when the valuations for the stocks were at their optimum levels – thus losing out on a better opportunity.

So the question you need to ask yourself here is – Would you rather invest in a fund that pays out dividend and dilutes your NAV or would you rather let the fund manage its NAV that in turn increases the value of your overall investment, and pay yourself a dividend whenever you require one?

We’ve made the choice of letting our investors declare their own dividend; and to invest your savings in a sensible way, focusing on the long term and on the need to identify and minimize risks that we take to give you a chance to earn long term returns. Hopefully you have made yours too.

*Source- Bloomberg

Above article is authored by Quantum.

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