Should you invest in Mutual Fund Dividend Option

At the time of investing in a mutual fund schemes, investors have to select whether they want to invest in Growth or Dividend Option. Investors should understand very clearly that, whether you invest in the Growth or the Dividend Option, there is no difference in the nature of investment – the risk return characteristics are the same.

Some investors think that dividend option is less risky – it is a misconception. In this blog post, we will try to understand the differences between growth and dividend options, how dividend options work and clarify misconceptions so that you are able to make informed investment decisions.

Mutual fund is essentially a pool of money from different investors. This money is deployed by the Asset Management Company (AMC) in buying different capital market securities. At the time of new fund offer (NFO), the AMC allots units at par value or face value, usually priced at Rs 10; the face value is same for both growth and dividend options. Over time the market value of the securities in the scheme portfolio changes with market movement. To report market value of investments for each investor of a scheme, AMC’s calculate the current market value on a per unit basis, adjusted for expenses, at the end of every business day – this is known as Net Asset Value (NAV). The market value of your investment will be the NAV times the unit allotted to you.

At the time of NFO, the per unit price of both growth and dividend options are the same. If the fund manager simply holds the securities in his / her portfolio, the NAVs of both growth and dividend option will be the same. However, from time to time, the fund manager sells some securities and buys some other securities. There are several reasons why fund managers may sell securities. He / she may think that the current market price of a security in the scheme portfolio has appreciated too much and is now expensive. The fund manager may also sell, if he (she) wants to rotate sectors, depending on sector outlooks. Whatever the reason, if the fund manager sells a security above its purchase price, then the scheme makes a profit. What to do with this profit?

Dividends are paid from scheme profits

It is important for investors (especially those who invest in dividend options) to understand the market regulator, SEBI’s position on “what constitutes profits”. Appreciation in NAV is not considered to be a profit. The fund manager has to sell securities at a price above the purchase price in order to make a profit – profit has to be associated with portfolio churning. In the growth option, the profit remains invested in the scheme. In the dividend option, a portion of the profit (subject to SEBI rules) is paid out to investors. Therefore, growth and dividend option are essentially profit distribution options.

Why growth and dividend options NAVs are different

In growth option, even if the fund manager makes a profit, the profit remains invested in the scheme, deployed in cash or stocks based on the fund manager’s call – there is no change in NAV. In dividend option, since the profit is paid to investors as dividends, the dividend amount per unit, is stripped from the NAV. The ex-dividend NAV (NAV after dividend pay-out), therefore, is lower than the cum-dividend NAV (NAV before dividend pay-out). For example, if the scheme’s NAV (dividend option) is Rs 50 when dividend is announced and the scheme pays a dividend of Rs 5 per unit, the ex-dividend NAV will be Rs 45. Every time a dividend is declared, it will be stripped out of the NAV.

Check the NAVs of a reasonably old mutual fund scheme, one which has been paying dividends regularly. You will see that the NAV of the growth option is several times higher than the NAV of the dividend option. This does not mean that the growth and dividend options were managed differently.

The fund manager is given a pool of money to be managed. He (she) does not distinguish between money invested in growth option or dividend option. The difference in NAV is due to accounting of dividends declared. In the growth option, the profits remain invested and therefore, over a long period of time the NAV appreciates many times more due to the power of compounding.

If you are looking for capital appreciation then you should invest in growth option. If you are looking for income, you can invest in dividend option. However, there is no guarantee that dividend will be paid and there is no assurance of a certain amount of dividend per unit. It is entirely up to the discretion of the AMC, as we will explain in the next section.

How much dividend can a scheme pay?

In the old days, mutual funds could pay dividends from unrealized gains; unrealized gain is essentially paper profit (NAV appreciation). Unrealized gains were booked in an accounting head, known as Unit Premium Reserve and schemes paid dividends from this reserve. However, in 2010, SEBI mandated that dividends have to be paid from realized gains (as discussed earlier) and not use the Unit Premium Reserve. Therefore, just because your scheme NAV appreciated, you should not assume that you will get dividends.

Let us now assume that, the scheme made a profit of Rs 5 per unit. From an accounting perspective, this profit is booked in a head known Dividend Equalization Reserve. Dividends can be paid from this reserve. However, you should not think that the entire Rs 5 booked in this reserve will be paid to you. The AMC may just pay Rs 2 to you as dividend and keep the balance Rs 3 in the Dividend Equalization Reserve for a rainy day, so that they can continue to pay dividends even during the period when the scheme is unable to realize profits.

Which schemes are likely to pay more dividends?

Investors often ask us, which schemes will pay more dividends. This question needs to be framed better depending on the financial objectives of the investor, because a scheme can pay very high dividend in a year and not pay any dividend for the next 3 years. Investors who are looking for regular income should be concerned more about consistency.

We discussed the accounting treatment of scheme profits and dividends so that you understand how dividends are paid. Dividends are paid from accumulated profits (in the Dividend Equalization Reserve). Schemes which have higher accumulated profits, not distributed as dividends (higher balances in the Dividend Equalization Reserve) will be in a better position to continue paying dividends to investors irrespective of market conditions. Older schemes are likely to have more accumulated profits than newer schemes and therefore, maintain better dividend pay-out track record. However, this does not speak about investment performance.

Dividend Re-investment Option

In dividend re-investment option, the dividend is not paid out to investors, but is re-invested in the scheme to buy more units. There is no regular income for the investor and dividend re-investment option is very similar to growth option. The difference between the growth option and dividend re-investment option is in NAV. NAV of dividend pay-out and dividend re-investment option is the same, but in dividend re-investment option the investor has more units. In terms of investment value, there is no difference between growth and dividend re-investment option, other than the impact of taxes.

Tax Treatment of Dividend Options

Mutual fund dividends are tax free in the hands of the investors, but the AMC has to pay Dividend Distribution Tax (DDT) before paying dividends to investors. Investors should note that, even in dividend re-investment options, the AMCs have to pay DDT before re-investing the dividends. Prior to this financial year, dividends paid by equity mutual funds or equity oriented hybrid funds (minimum equity allocation of 65%) were tax free. However, in this year’s Union Budget, the Finance Minister announced 10% DDT for equity mutual funds. For debt fund or hybrid funds (where gross equity allocation is less than 65%), the AMC has to pay DDT at the rate 28.8% before paying dividends to investors.

The tax changes for equity mutual fund dividends have implications on tax advantage of dividend re-investment versus growth option. Short term capital gain (STCG) in growth option is subject 15% tax, whereas in dividend re-investment option, the AMC has to pay DDT of 10%. So for investments held for a period of less than 1 year (short term capital gains or STCG), dividend re-investment option continues to enjoy tax advantage over growth option, but the advantage is not as big as it was before.

For investments, held for more than 1 year, growth option clearly has an advantage over the dividend re-investment option because investors enjoy Rs 1 lakh exemption as long term capital gains (LTCG) tax. Beyond Rs 1 lakh, long term capital gains are taxed at 10%, same rate as DDT in equity funds.

In debt mutual funds, for holding periods of less than 3 years, dividend re-investment option is more tax efficient than growth option for investors in the highest tax bracket because short term capital gains (holding period of less than 3 years) in debt funds are taxed as per the income tax rate of the investor. However, for investors in the lower tax brackets, growth option is more tax efficient. Long term capital gains (holding period of more than 3 years) is taxed at 20% after allowing for indexation benefits. Growth option is clearly far more tax efficient than dividend re-investment option for long term debt investments.

Conclusion

Whether you go for growth or dividend options, will depend entirely on your investment needs. If you need regular cash-flows then you can select dividend option, otherwise growth option is more suitable. There are several dividend pay-out options like daily dividends, monthly dividends, quarterly dividends, annual dividends etc, which varies from scheme to scheme. Select the dividend option based purely on your needs.

Based on queries / comments received at Advisorkhoj in the last 1 year or so, there is a lot of interest in dividend option. However, investors should have reasonable expectations when investing in dividend options, especially our senior citizen readers, who rely on investment income. It is important that you first select the right scheme based on your risk appetite – scheme option is irrelevant in matching risk profile of the investment with your risk appetite. Once you have selected the scheme, you can select the option which is more suitable for your needs.