Don't leave dividend income idle in bank

If young, choose the growth option. But if you are earning dividends, invest it to maximise gains.

Investors tend to give a lot of time and importance to the process of selecting a mutual fund. However, one may not really be particular about the kind of investment options the fund allows him. One can choose between the dividend or growth option of a fund. Choosing the correct option is perhaps as important to the health of the investment as choosing the particular mutual fund. Let us look at the various factors, one should consider before taking a decision and why.

MAXIMISING GAINS
Factors that are of prime importance when choosing the investment option — are the policy on taxation and your own investment needs and goals. Both these factors play an important role and let us see how we can tweak each for the maximum benefit.

Benefits and drawbacks of choosing the dividend option. Let us look at the benefit of choosing the dividend option. Mutual fund houses always sell the dividend options as a tax-free option. But between, debt and equity schemes , only equity schemes are truly tax-free. The dividends received from non equity-oriented schemes are subject to a distribution tax (DDT) of 12.5 per cent. This is not be taxed at the hands of customer but it still means that you are receiving 12.5 per cent lesser than what you would have otherwise received. Which by inference means that it is you who is bearing the 12.5 per cent tax, the mutual fund only pays it on your behalf. However, for those investing in equity schemes, the dividends are truly tax-free.

Then shouldn’t all investors choose the dividend option? Let’s not jump to conclusions so fast. Let’s consider an example, that of HDFC Equity Fund, a scheme that has been in existence since December 1994.

As on November 15, the net asset value (NAV) for the growth option of HDFC Equity Fund was Rs 240.63 whereas that of the dividend option was Rs 40.65. Why is this? The difference of Rs 199.98 per unit is largely nothing but your own money paid back to you (by calling it dividend). The investor who has chosen not to receive the dividend is owed Rs 240.63 per unit by the scheme whereas an investor choosing the dividend option is owed only Rs 40.65.

It should be understood that dividend from a mutual fund, unlike a 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 240.63 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 40.65.

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 or the IRR. But without going into the mathematical jargon, suffice it to say that the fund performance (which has been nothing less than spectacular) is based on the NAV of Rs 240.63 and not Rs 40.65.

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!

The second problem is that you may forget that the scheme has paid dividend and the money is lying in your bank. At times, one may let the money lie simply because the market is volatille and one would rather delay one’s decision to enter.

This will result in a fall in your rate of return. Because , the capital invested in the fund is growing at the IRR as discussed above (around 19 per cent over 3 years and almost 20 per cent since inception), while the dividend in the bank is growing at just 4-6 per cent per annum which may be the savings bank interest rate after deregulation. 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.

OPT FOR TAX ARBITRAGE
Of course there are a couple of excellent reasons for choosing the dividend option. The first one is of course that you may need the funds for day to day life. The second one is that getting dividend in a rising market is like partial profit booking. The funds representing dividend can be invested into fixed income avenues thereby rebalancing the asset allocation.

Or take the case of debt funds. If your investment time frame is less than one year, by choosing the growth option you would be subjecting yourself to short-term capital gains tax. Short-term capital gains are to be added to your other income and taxed at the slab rate applicable to you. Which means that if you fall in the highest tax bracket, you will end up paying 30 per cent tax on the short-term gains. You would be much better off choosing the dividend option and bearing the distribution tax of 12.5 per cent . This strategy is known as tax arbitrage.

A further refinement of the above strategy is to choose the dividend reinvestment option. This way, each dividend that is paid is allotted units and the dividend itself becomes the cost of such units. Ultimately, you will find that the short-term gains are further reduced on account of this notional cost.

TO SUM
The psychology of investing, the taxation on the returns and your requirements from your investments, all go hand in hand in deciding the optimal option to choose from.

The writer is Director, Wonderland Consultants