Many investors think that a fund's dividend option is more profitable, but that is not really true
27-May-2008 •Research Desk
Arun Chhabaria is a first-time investor. He’s seen the Sensex rally unfolding in the news channels everyday and has read about its record-breaking achievements in the newspapers. People around him are raking in large amounts of profits, albeit at a high risk factor. Arun Chhabaria wants a piece of the pie as well, but he can’t handle the high risk that comes with direct equity investments. Someone suggested mutual funds and after having studied them for a while, Chhabaria decides that mutual funds are just the right kind of investment he’s looking for. They provide decent returns and are not as risky as equities. So the time has come for him to pick the funds he wants to invest in. He’s decided on a particular fund but is pondering over the three options that scheme offers: dividend, dividend investment and growth. He notices that under the dividend option, the fund keeps declaring dividends regularly but no such payments occur under the growth option. This leads him to assume that the dividend option is much more yielding and profitable. However, like many other such investors, Arun Chhabaria is wrong.
When mutual funds are looked at from a pure investment-yield point of view, it doesn’t matter which option one invests in. Dividends are often perceived as indicators of a fund’s performance. This of course is not true, as dividends are just deductions from your fund account. In a growth option, this same money would be added to your account, as against passing it on to you in the form of dividends. For example, when an investment of Rs. 2,000 is made at an NAV of Rs. 20 per unit, you get 100 units of the fund. The fund then gains 20 per cent, bringing its NAV to Rs. 24 per unit and thus making the investment worth Rs. 2,400. Now, the fund declares a dividend of 50 per cent, thus paying Rs. 500 (dividends are always a percentage of the face value). Now, the NAV will go down to Rs 19 and thus the value of the holdings will go down from Rs 2400 to Rs 1900. Basically, all that has happened is that a part of the holdings had been handed out to as dividends. There was no extra benefit. However, dividends do have an advantage. While you may not get anything extra, you could end up saving some tax. Firstly, dividends from equity mutual funds are fully tax-free. This is one of the most tax friendly ways of receiving returns from equity mutual funds. These tax-free dividends can also be used to offset short-term capital gains.
On the debt side, a dividend distribution tax of 14.1625 per cent (12.5 per cent plus 10 per cent surcharge plus 3 per cent education cess) is levied on all dividends paid by a fund. This tax is levied on the net amount that a fund wishes to distribute as dividend. Thus if a fund wants to give investors a dividend of Rs 100, it will have to book profits of Rs 100 plus 14.1625 per cent of Rs 100. So the fund will declare a gross dividend of Rs 114.1625. Of this Rs 14.1625 will go to the government, as dividend distribution tax while the investor will receive Rs 100 as dividend.
Investors though should opt for an option that minimizes their tax liability. If dividend income is tax-free (as is the case with dividends from equity-funds) then the dividend option or the dividend reinvestment option is a good bet. If capital gains are tax-free (as is the case currently with equity-oriented funds) then choosing the growth option would probably be more viable. And if both are tax-exempt, then the net returns from any of the above options would be identical.