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Last week we discussed the fact that dividend received from a mutual fund is essentially return of capital and not return on capital.
An unclear understanding of this concept often results in sub-optimal investments. Based on reader feedback, this week we shall visit two related issues:
1. What’s the difference in the performance of the dividend option vis-à-vis growth option?
2. Which option serves investor interest best — dividend, dividend reinvestment or growth?
Choosing the dividend option
The most obvious benefit of choosing the dividend option 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 a distribution tax of 14.16%, which means, though such dividend is tax-free in your hands, you are receiving 14.16% lesser than what you would have otherwise received. This, by inference, means it is you who is bearing the 14.16% 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?
Let us revisit last week’s example. As on March 31, the NAV of the growth option of HDFC Equity Fund was Rs165.79, whereas that of the dividend option was Rs38.25. The difference of Rs127.54 per unit is largely nothing but your own money paid back to you (in the name of dividend). The investor who has chosen not to receive the dividend is owed Rs165.79 per unit by the scheme whereas the investor choosing the dividend option is owed only Rs38.25.
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).
So, both options will have the same performance level. Without going into the mathematical jargon, suffice it to say that HDFC Equity’s performance is based on the NAV of Rs165.79 and not Rs38.25.
So far so good. As long as you needed the dividend, all this really doesn’t matter. But, 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, HDFC Equity) in the first place. Plus, you may have to bear a load for the fresh investment. The fund is happy because the load is an extra income for it and of course, your distributor is happy since this means extra commission.
The second problem is of 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 is behaving whimsical and this volatility is delaying 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 on your investment is falling. The capital that is invested in HDFC Equity is growing at the IRR as discussed above (33% for the last year, 40% over 3 years and almost 25% since inception).
However, the dividend that is lounging in the bank is growing at just 3.5% p.a., which is the SB interest rate. 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
There are a couple of excellent reasons cited by investors for choosing the dividend option. One, they need the funds for day-to-day life and two, that getting a dividend in a rising market is like partial profit booking. The funds representing dividend can be invested into fixed income avenues or even fixed maturity plans, thereby rebalancing the asset allocation, they say.
But there is one hitch. There is no fixed periodicity for dividends from mutual funds. One never knows how much one would receive and when. In other words, the fund manager may decide not to distribute dividend, or he may decide to distribute much less or much more than what you need.
What do you do?
There is a simple solution. Ask for the dividend yourself. Yes, you read that right — ask for the dividend. As mentioned last week, when the MF pays you money, it is called dividend, but when you yourself withdraw an equivalent amount, it is called capital gain.
We all know that after one year, withdrawals (capital gains) from a mutual fund are tax-free.
Therefore, for your annual dividend requirement, do not depend on the whims of the mutual fund concerned; instead withdraw the funds as per your requirement.
This way, you can earn dividend not at the whim of the mutual fund, but at your fancy. The value of your investment remains the same, whether dividend is paid to you by the MF or you redeem units of an equivalent amount.