Dividend or growth, which option to take?

Unless you need the money for day-to-day needs, let it grow

Over the years I have noticed 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 is done almost arbitrarily.

Some like the idea of receiving periodic dividend and some like recurring investments and hence choose the dividend reinvestment option, while others choose growth.

Some even leave the entire exercise to the discretion of the agent or distributor.

So, when you invest in a mutual fund, which option should you ideally choose — dividend or growth? This decision is significant as it may directly affect the performance of your investment.

Let us start by considering the benefits of choosing the dividend option. The foremost and the most obvious benefit is that the dividend is tax-free.

Shouldn’t all investors then choose the dividend option? Isn’t this entire discussion a non-issue? Not so fast, not just yet.

Let’s consider an eg — that of Reliance Growth Fund, a scheme that has been in existence since November 1993.

As on November 23, 2007, the NAV of Reliance Growth under the growth option was Rs 428.76, whereas that under the dividend option was Rs 74.03 — almost 83% lower. Why is this?

The difference is significantly on account of the dividend received by the investor over the years.

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 Rs 428.76 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 74.03.

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, suffice to say that the scheme performance (which has been nothing less than spectacular) is based on the NAV of Rs 428.76 and not Rs 74.03.

As long as you need the dividend, all this really doesn’t matter. But, what 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, realise that you are reinvesting the money in the same asset class — equity.

If that is the case, it needn’t have come out of the asset class (in this case Reliance Growth) 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 that you may forget that the scheme has paid dividend and the money is lying in your bank account. It happens. Even if you are well aware of it, the market volatility may be delaying your decision to enter again.

All this time, while the money relaxes in your bank account, the rate of return on your investment has been falling. The reason is simple arithmetic.

The capital that is invested in Reliance Growth is growing at the IRR as discussed above (59% for the last year, 60% over 3 years and almost 71% over 5 years).

However, the dividend that is lounging in the bank is growing at just 3.5% p.a., which is the savings bank 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.

Of course, there are a couple of excellent reasons for choosing the dividend option. One is the funds are needed for day to day expenses.

The second is that getting dividend in a rising market is like partial profit booking, which is a good form.

The funds representing dividend can be invested into fixed income avenues or even fixed maturity plans, thereby rebalancing the asset allocation.

But, there is one hitch. Unlike fixed income avenues (such as PPF and RBI bonds, etc), when the interest is paid at fixed intervals, dividends from mutual funds are at the discretion of the 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 than what you need, or much more than what your intended shift of the asset allocation dictates. What do you do?

There is a simple solution. Ask for the dividend yourself. Yes, you read that right. You can ask for the dividend.

To put it differently, when the MF pays you money, it is called dividend, but when you yourself withdraw an equivalent amount, it is called capital gain.

We know that after one year, withdrawals (capital gains) from a mutual fund are tax-free. Therefore, for your annual dividend requirement, do not depend upon 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 whether you redeem units of an equivalent amount.

To put it succinctly, if you want your investments to grow, take the growth option.

sandeep.shanbhag@gmail.com