Raj, a 27-year-old I.T. professional, is chalking out his financial plan with his financial planner. He is willing to invest in mutual funds, however, he is unable to decide which investment option will be the right one to achieve his financial goals.
When investing in a mutual fund scheme, investors have numerous options available such as – growth, bonus, dividend reinvestment, and dividend payout.
Growth Option – In this case you do not receive any dividends directly. Instead, all the gains earned are re-invested and hence you enjoy compounded growth in the value your fund, the conditions, of course, are subject to the investment bets the fund manager makes.
Bonus Option – Under this option you are not paid regular dividends. Instead you continue to receive bonus units in accordance to a ratio declared by the fund house. (Quite a few mutual fund houses do offer this option)
Dividend Payout Option – Here the distributable surplus/profits are proposed to be paid, either through cheques or ECS (Electronic Clearing Service) credits, thereby facilitating to liquidate profits.
Dividend Re-Investment Option – With this option, the dividends declared by the mutual fund scheme, instead of being defrayed, is further used to buy additional units of the same scheme (where you are invested). So, you continue to book profits and re-invest in the same scheme.
But is this sharing of profits, in the form of dividends, really for the benefit of investors or is there a hidden intention of the fund house?
At one point, Raj was willing to invest in growth options and enjoy the power of compounding; the lure of high dividend declarations was too good to pass. Below are the four myths that many investors, like Raj, have related to dividends declared by a mutual fund:
#1 Myth: Frequent dividend declaration is an indicator of fund’s performance
Often the dividend declared by a mutual fund is co-related to the dividend earned on the equity portfolio. But unlike the dividend earned through investment in equity shares, where the company distributes its profits earned with shareholders; in case of mutual funds, it is a function of the market movement (usually upward) resulting in partially books profit with an impact on NAV (Net Asset Value).
For example, when the NAV of a mutual fund scheme is Rs 12 and a 20% dividend is declared, i.e. Rs 2 (20% on the face value of Rs 10/-), the NAV of the fund ex-dividend falls to Rs 10 on account of dividend declared, plus it may be exposed to downside volatility. Thus, in effect, mutual funds return your own money back.
#2 Myth: Dividend options have lower NAV; translates into a buying opportunity
You may have observed that the NAV of a dividend option is lower than that of a growth option. This is because, as and when dividends are declared, the fund NAV continues to decline post the dividend record date.
And often many mistake this fall in NAV as a buying opportunity. They fantasize that they will earn similar dividends or even higher, even in the future. As result, many evince interest and the size of the fund goes up.
In the race to garner more AUM (Assets Under Management) in the past, fund houses have resorted to tactics of declaring abnormally high dividends, but in the long run investors who fell prey to this were left with empty baskets.
#3 Myth: Dividend History
Investors often give high emphasis to fund’s dividend history, using it as measure to select mutual fund schemes for their portfolio. They assume that the dividend trend will continue going upward. But what they fail to recognise are the undercurrents – the market and the portfolio – may turn unfavourable and impede dividend declaration.
It is easier to declare dividends when markets are doing fine, but you should always check if the fund has performed equally well across market cycles, and if it has declared similar dividend rates during the ‘bear’ phase of the market. This will help you gauge the consistency of a mutual fund scheme fund to an extent.
Hence one should not consider only the dividend history in isolation. It is important to study a host of quantitative and qualitative parameters before selecting mutual funds.
#4 Myth: Dividend can be regular source of income
While many a times mutual fund distributors/ agents / relationship managers promote the dividend option as against the growth option. They attempt to lure investors claiming that it could serve as a source of regular income. But the fact is mutual fund schemes don’t guarantee regular dividends. There is no set schedule for the payment of dividends, nor are the dividend rates predictable. If fund falters as a result of the negative currents, dividends may be hindered. Hence you cannot depend on the dividend declared by mutual fund schemes for regular income/ cash flow.
To conclude...
It all depends on what your financial goals and investment objectives are while selecting between various investment options. If you’re young, earning a substantial income, commitments toward certain expenses are low, willingness to take risk is high, are many years away from your financial goals and your long-term objective is wealth creation you should invest in a growth option.
However, despite the financial planning aspects stated and the regular income earned, if you are still looking for a cash flow (in the form of dividend) or want to book profits at regular intervals, then you may consider the dividend payout option while investing in mutual funds.
As far as the dividend re-investment option is concerned, in our opinion it just doesn't make sense as the same benefit of compounding is also provided under the growth option with the NAV (of the growth option) being unchanged (due to the impact of dividend declaration). The dividend re-investment option is just another financially engineered option provided by mutual fund houses.
Mind you, there is no guarantee that there will always be a fixed dividend declaration. So the next time your relationship manager or agent presents you with the dividend over growth option; adopt the right rationale.
