Choosing the right mutual fund option: Growth or dividend

Introduction

A financial asset draws investors because of two attributes: (1) capital appreciation; (2) frequent cash flows. Mutual funds are no different. Most investors in mutual funds look for both these attributes depending on their investment objectives and investment horizon. Some investors may look for growth (capital appreciation), some may primarily look for income (frequent inflow of cash), while some may look for a combination of both. For all mutual fund investors, the scheme may offers these two options and the investor can look for the above attributes.

Dividend and growth options

For a mutual fund investor, one of the key decisions after selecting a scheme is to decide whether to invest for growth or dividend or both. The suitability of these options depends on the investor’s objectives, horizon and subsequent tax treatment. Before an investor chooses one of the growth or dividend options, let us have a look at the basic differences between the two.

Differences between dividend and growth options

• Securities Transaction Tax (STT) shall be payable on equity oriented mutual fund schemes at the time of redemption / switch to the other schemes / sale of units. ^Units held in equity-oriented schemes for a period of more than 12 months is considered as Long-Term Capital Gains and for a period of 12 months or less is considered as Short-Term Capital Gains. Units held in debt-oriented schemes for a period of more than 36 months is considered as Long-Term Capital Gains and for a period of 36 months or less is considered as Short-Term Capital Gains.
• Income-tax at the rate of 10% (without indexation benefit) on long-term capital gains exceeding Rs. 1 lakh provided transfer of such units is subject to STT.
• Surcharge at 15% on base tax, is applicable where income of holders exceeds Rs. 1 crore but does not exceed Rs. 2 crores and at 10% where income exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore. Further, Health and Education Cess @4% is to be levied on aggregate of base tax and surcharge
• Long term Capital Gain tax on debt-oriented schemes will be calculated after giving indexation benefit

The above tax rates are as per the current tax laws and are subject to change.

How to choose between the two options?

Now that you have understood the basic differences between the two options, how do you decide on the choice of investment for you? The answer lies in factors such as investors’ objectives, holding period and incidence of tax.

Investment objective – In case investor’s investment objective is to grow your investments, then the growth option should be chosen. However, in case of dividend option investor may get inflows but not at fixed intervals. Investors should note that the frequency of dividends payouts and their quantum is in the hands of the fund house and are based on the surplus available with the Scheme for dividend distribution. Hence, in case investor have a fixed number for inflow in his/her mind, then the dividend option might not suffice. Instead investor can opt for systematic withdrawal plans (SWPs), especially for goals such as money flow after retirement.

Investment horizon – In case investor’s investment horizon is long, then the growth option should be chosen, as it helps in accumulating wealth and benefitting from compounding of the money.

Taxation – As detailed in the differences, taxation differs between both the options. Investors should look at the best possible alternative for them to reduce the tax incidence. Factors such as investment horizon and objectives go hand in hand with the taxation regime, and hence investments should be accordingly mapped. For instance, you have an investment horizon of three years while investing in debt funds, with not much need for inflows in the intermittent period, then growth option should be the choice. By doing so, investors reduce the tax incidence on dividends received and also benefit from LTCG and indexation benefit.

In addition, before choosing one of the two option, investors should keep a note of the following points:

1. Dividend is not guaranteed – Investors should note that mutual funds do not declare dividends at regular intervals. In fact, dividends are not even guaranteed, as per the Securities and Exchange Board of India’s (SEBI) rules, a mutual fund can only declare a dividend from its realisable surplus or the actual profits that it books from the sale of its underlying securities. Any unrealised gain from a rise in the prices of its equity and bond portfolio holdings does not count since this gain is transferred to its unit-premium reserves, which cannot be used to distribute dividends
2. Growth option can be better – When the mutual fund distributes dividends from its profits, its corpus gets reduced to that extent, and that is reflected in its lower NAV. By taking a dividend, the investor is withdrawing a part of his investment. On the other hand, in the growth option there is no outflow from the investment and hence the fund’s corpus grows, as the market value of its holdings rises. This larger corpus then can reap the benefit of sheer power of compounding.
3. Choose an SWP – An investor should choose an SWP and not the divided option if his/her objective is regular income. Investors in need of a regular income stream often consider dividend option as viable. However, as mentioned above, mutual funds do not declare dividends at regular intervals. There are times when the fund may not declare the dividend. Dividends are also subjected to tax as mentioned above. Hence, investors looking for a regular income stream could consider opting for an SWP instead. With the SWP, an investor can determine both the periodicity of the cash flow from his mutual fund investments and also the quantum.
   

Let us consider a hypothetical illustration wherein investors A and B want an annual cash flow of Rs 10,000 starting 2012 from an investment of Rs 10 lakh made in 2011. Investor A choses an SWP of Rs 10,000 annually from an equity fund, while Investor B prefers the dividend option of the same fund. As seen in the below cash-flow structure, Investor A enjoyed pre-determined cash inflows, thanks to the SWP option. On the other hand, Investor B had to face a shortfall, due to a low or zero dividend sum received in some years (as represented in red below).

Illustration is hypothetical and for education purposes only and without considering taxation effect Investors should note that a dividend payout is solely at the mutual fund’s discretion

Since the SWP can be made from both the capital appreciation portion and also the principal, if there is a shortfall in the former, SWP might probably provide a pre-determined income stream regardless of market fluctuations. Further, there will be no tax, if the withdrawal through SWP are less than Rs 1 lakh, while the dividend option attracts the dividend-distribution tax (DDT). However, investors should note that withdrawing any amount in the early years of investment is subject to an exit load as per the provisions of the Scheme Information Document of the Schemes.

Summing up

As seen above, both the dividend and growth options have pros and cons. The selection of a right option is pertinent for successful financial planning. An investor can also consult a financial advisor to map the right option holistically with overall financial planning.

Investors shall always refer to the Scheme Information Document and Key Information Memorandum of the schemes carefully to understand the investment objective and associated risk factors of the mutual fund scheme before investing.

Disclaimer:

Any comparison mentioned in this material is for general information only and not intended to be relied upon as investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Information and content herein have been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. Recipient are advised to seek independent professional advice before making any investments. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. SBI Mutual Fund / SBI Funds Management Private Limited is not guaranteeing or promising or forecasting any returns. In view of the individual nature of the tax consequences, each investor is advised to consult his/her own tax consultant with respect to specific tax implications arising out of their participation in investments.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.