Dividend, re-investment or growth?

Mutual fund houses often use dividends as a means to attract inflows to equity linked saving schemes (ELSS) in the first quarter of the calendar year. That leads investors to seek help in identifying which option is superior when investing in equity funds: Dividend, dividend-reinvestment or growth?

Dividend for companies is routinely paid out of the profit, but in a mutual fund, if the fund house thinks the market is overheated or finds it difficult to deploy funds, it may sell a part of the portfolio and pay back the capital appreciation as dividends to the investors.

Dividend and growth are the two common options provided by mutual funds to the investors. Under the dividend option again, investors are allowed to choose between payout and re-investment. Here is a look at how investors should decide between options, generally, and with specific reference to ELSS:

Dividend option: Under the dividend option a certain percentage of the capital appreciation is paid back to the investors in the form of dividends. A point worth noting here is that the amount distributed to the investors comes out of the fund's NAV. If the NAV of a scheme is Rs 30 per unit and if the fund declares a Rs 5 per unit dividend, the ex-dividend NAV of the scheme will settle at Rs 25. So, dividend is just one way of taking out your profits from the investment.

If you are a long-term investor, remember that dividend payouts actually bring down your portfolio value. Having said this, the major advantage of the dividend option is that if the market undergoes a steep correction, such as the one witnessed in 2008, the sums already taken out by you through dividends will be protected.

But if you are looking to build a portfolio for the long term, it may be better to fix a return target and use the dividend transfer plan to invest dividends in debt funds or monthly income plans to protect your profits. If your key reason for investing in a fund, like an ELSS is tax savings, then the dividend option is better for you.

Dividend re-investment: Returns under growth and re-investment options are almost the same. Under dividend re-investment option, once the dividend is declared, the fund house buys additional units of the scheme on the ex-dividend date at the prevailing NAV and adds it to your investment. The number of units held in the scheme will increase.

Under the growth option, based on the appreciation in the stocks held in the portfolio, the NAV itself will increase.

At the time of redemption, the value of your portfolio will be almost the same, whether you opted for re-investment or growth. The reinvestment option value would be slightly higher because of the tax benefit on dividends received.

Re-investment vs growth: The advantage of the re-investment is that re-invested dividends are eligible to be treated as fresh investments under Section 80C of the Income Tax Act under an ELSS scheme. For example, if you invested Rs 50,000 in a scheme in November 2007 just before its dividend declaration when its NAV was Rs 46.89, the current value of investment works out to Rs 50,125 under the dividend re-investment option.

Had you preferred the growth option your investment value would be Rs 49,575. The reason for this difference is that in the last two years the fund has declared three dividends that amounted to Rs 16,897 in total. If you were in the 30 per cent tax bracket you could have enjoyed tax benefit of Rs 5,070 on those dividends and that is the gain over and above the Growth option.

The only flip side of dividend reinvestment in an ELSS is that dividends reinvested too will carry a three year lock in period and that may prevent you from cashing out fully when your original investment completes three years.

Investors who opted for the dividend re-investment option can stay invested under this option as long as they have room for the same under section 80C.

Alternatively, if you have exhausted the Rs 1 lakh threshold for investing under Section 80C, the dividend transfer plan would be a better bet.

If an investor chooses the growth option at the time of investment in an ELSS, he is not allowed to switch to other options before the completion of the three-year lock-in period. So, before writing out your cheque for an ELSS, select your option based on your requirements.