Growth or dividend? A tough option

Dividend payouts may work at times because only the original investment is exposed to volatility.

Raju Nair is a disciplined mutual fund (MFs) investor. He prefers the ‘growth’ option for his long-term MF investments. He believes his investment will grow at a higher rate if he chooses the growth option.

Like him, most MF investors prefer the growth option. However, does it make sense to do so? Most of us are willing to take risks once. But next time, we look at alternatives to avoid or reduce the risk. A similar strategy can be used for MF investments.

RISK IN GROWTH OPTION
Every rupee invested in equity funds is at risk. Most people are disciplined while investing in equity funds, say via SIPs. But are rarely as disciplined while booking profits. Similarly, they are cautious about investing in falling markets but rarely exercise the same caution while booking profits when markets are move up. Financial years like 2006 and 2010 have seen funds earning returns, ranging between 60 - 110 per cent. However, not many investors cashed out, choosing the ‘growth’ option and keeping the principal money plus the growth on it invested at an equal risk hoping for higher returns.

REINVESTMENT OF DIVIDEND PAYOUT
The ‘dividend payout’ option forces the investor to receive some part of the profits earned during a year by way of dividends (tax-free in the hands of investors). These should be regarded as profits booked on risky investments. Thus, an investor should ensure these profits are not exposed to the same kind of risk as the money that generates them. These dividends (accumulated over a year) should be further invested in risk-free instruments like fixed deposits to safeguard an investor’s return on the risky investments. This strategy ensures only the capital is exposed to risk, leaving the profits safe. An analysis of the four funds (as mentioned in the table), which have given good dividends since investment, irrespective of current market value of existing investment, shows that the difference in growth rates earned over an average of a five-year period between the ‘dividend payout-debt reinvestment’ strategy (as described above) vis-a-vis the growth strategy is only about four-five per cent. For the purpose of this analysis, the reinvestment rate for the debt instruments has been considered at eight per cent per annum . The table shows how Rs 1 lakh invested in each of the four schemes on March 31, 2006 would have increased using both strategies.
   

Fund	A	B	C	D	E
HDFC Equity Fund	44,814	55,218	124,866	13%	16%
HDFC Top 200 Fund	74,566	86,854	118,490	16%	16%
SBI Magnum Contra Fund	60,170	74,991	72,727	8%	10%
Franklin India Prima Plus Fund	60,170	70,892	73,877	8%	13%
A - Dividends received during April 1, 2005 to March 15, 2011 in Rs  B - Value of dividends reinvested in FDs @ 8% p.a. in Rs  C - Market value of initial investment of Rs 1 lakh as on March 15, 2011 in Rs  D - CAGR as per the ‘dividend payout-debt reinvestment’ strategy E - CAGR as per growth strategy

BENCHMARK
A fundamental principle in financial planning is to set benchmarks for investments made for various goals and objectives. Typically, for equity diversified MFs, most planners prefer long-term growth rates of 12-15 per cent. Planners feel most goals can be achieved at these rates. As per the table, the ‘dividend payout-debt reinvestment’ strategy returns by the two HDFC funds earns average annual returns of 16 per cent.

This strategy yields similar results for systematic investments over a period of time as well as lumpsum investments. So, given the volatile nature of the markets, it is safer to plough back the dividends in safe instruments and expose just the capital to risk. The writer is a certified financial planner