Sep 07, 2012 03:19 PM IST | Source: CNBC-TV18

Choose wisely between dividend and growth option

Many mutual fund investors face a common dilemma. Should you choose growth, dividend payout or dividend reinvestment option? While each option is distinctly different, earning potential vests in all three.

Many mutual fund investors face a common dilemma. Should you choose growth, dividend payout or dividend reinvestment option? While each option is distinctly different, earning potential vests in all three. One needs to understand one’s financial needs to choose the right option, advises Hemant Rustagi of Wiseinvest Advisors.

The growth option, as the name suggests, allows investors to make their money grow over a period of time. So, anyone who is looking to build his corpus over a period of time should look at growth option.

As far as dividend payout option is concerned, those investors who would like to receive dividend on a regular basis, can opt for it. The major advantage here is that the dividend that comes in the hands of investor is tax free.

Dividend re-investment is not advisable for investors especially who invest for the long term. It’s ideally suitable for investors who want to park their money for couple of months in funds like liquid fund or ultra short term fund.

Below is the edited transcript of Rustagi's interview with CNBC-TV18.

Q: While investing in mutual funds, how should an investor decide between which option to pick - dividend pay out, dividend reinvestment or growth. Also, should one keep interchanging between these options depending on the market conditions? How would it imply for an equity mutual fund and a debt mutual fund?

A: As far as selecting an appropriate option is concerned, I think it’s a very important aspect of mutual fund investing. In fact, I would say it’s as important as selecting the right scheme. But this is unfortunately one aspect which is generally ignored by the investor.

Let’s begin with growth option. As the name suggests, it allows investors to make their money grow over a period of time. So, anyone who is looking to build his corpus over a period of time should be looking at growth option.

The reason for that is, in the growth option, whatever gains are made on an investment remain invested in the fund itself. This means that one gets the advantage of the power of compounding over a period of time. This is very important especially for someone who wants to build his corpus over a period of time.

The second aspect is that the growth option ensures that the returns that an investor gets become more tax efficient, and that depends on the kind of scheme that money is invested in. For example, if the money is invested in equity funds, capital gains, on an investment which is redeemed after a period of 12 months, are tax free. In case of debt fund, it is tax at a concession rate of 10%.

In fact, there is another option for an investor, that is to claim indexation benefit. In a country like ours, where generally inflation is quite high, it makes sense to claim indexation. For example, if the return from a debt fund is 10% and the inflation is at 8%, the tax has to be paid only on 2% which is at 20%. So, the post tax return turns out to be 9.6%.

If you were to compare it with a traditional option like fixed deposit (FD), although you get the same return, if you are in the higher tax bracket, you end up paying 30% tax on that. So, as against 7% you get 9.6% so growth option is suitable for investors who wants to make their money grow.

As far as dividend payout option is concerned, those investors who would like to receive dividend on a regular basis, can opt for it. Of course, the frequency of the dividend depends on the kind of fund one is invested in. Equity funds give you dividends once in a year. But many of the debt funds have the option of either getting dividends on a daily basis or a monthly basis or a quarterly basis.

The major advantage here is that the dividend that comes in the hands of investor is tax free. But in case of debt funds, the funds have to pay dividend distribution tax, which for individuals, is 13.52%. For those investors who are on the higher tax bracket of 20% and 30%, there is a clear tax arbitrage.

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In the case of dividend re-investment, it’s a mix of these two. What happens is that the dividend is declared, paid and re-invested at the post-tax NAV. Every installment of dividend that comes for the investor, which is re-invested, has to remain invested for the next 12 months for the gain to become tax free.

I don’t think it’s advisable for investors especially who invest for the long term to look at dividend reinvestment. It’s ideally suitable for investors who want to park their money for couple of months in funds like liquid fund or ultra short term fund because there if someone who is in the higher tax bracket of 20-30% the fact that dividend distribution especially in the ultra short term is 13.52%, it makes great sense to look at dividend reinvestment.

Q: What is the nomenclature normally used for a dividend fund?

A: Yes, they are a variety of debt funds. There are liquid funds, ultra short term funds, short term debt funds, income funds and debt-oriented hybrid funds called monthly income plan. Not just debt funds, even equity funds give dividend but the frequency of that cannot be pre-decided.

In case of equity funds, whenever the fund manager books profit, he pays dividend out of that. In the case of debt fund, the money is invested in interest bearing securities; the fund manager can be sure of at what frequency he can pay the dividend. That is why one gets to choose frequency of whether it is going to be monthly or quarterly or sometimes, even annually. So, all the funds have these options.

Q: Should investor switch from growth to dividend payout option? If he wants money on a monthly or a quarterly basis what should he do?

A: As I mentioned earlier, every fund has three options - growth, dividend payout and dividend reinvestment. Two things have to be looked at. One is, you should decide your asset allocation first. You decide whether you want to invest in an equity fund or a debt fund or a hybrid fund. Thereafter, you need to assess as to how you would like to receive your returns? Whether you would like to have regular dividend or growth or you want to have both.

Definitely, opting for a dividend payout will be clear strategy to get regular dividend. But if you have been investing in equity funds, the frequency of the dividend is not decided. The fund may give you dividend once in a year, and if your requirement is on a regular basis, you have to necessarily look at bond funds or debt funds. In that you have different categories. One category is the monthly income plan, which is a debt hybrid fund, which invests in equity and debt. 20% is invested in equity and the rest is in debt.

You have an option of either opting for a monthly dividend. This means that every month the fund will give you some dividend or you can opt for a growth option if you want your money to grow. Since your requirement is of regular dividend, you need to choose the right fund. Merely changing options in an equity fund may not give you the kind of money that you require regularly.

Another option for you is that you can setup a Systematic Withdrawal Plan (SWP). What it does is you can give standing instruction to the fund house saying you redeem ‘X’ amount of money every month on a particular date and the money will come to you. With this, you are assured of getting a regular amount, whatever your needs are that can come through SWP. So the key factor is decide the right kind of fund based on the asset allocation.

Every fund will give you options of dividend, dividend reinvestment and growth. Choose the one that suits your requirement. Within dividend payout, there are different frequencies, which are allowed. You can actually look at monthly dividend, quarterly dividend and some will give you even half yearly dividend.

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