Selection of mutual funds for investing


Mutual Funds (MF) offer three options:
· Dividend
· Dividend Reinvestment and
· Growth

Investors tend to give a lot of time and importance to the process of selecting a mutual fund. However, once a particular fund is chosen, choosing an investment option is done on an almost arbitrary basis.

Some like the idea of receiving periodic Dividend, some like recurring investments and hence choose the Dividend Reinvestment option and others choose Growth. And some even leave the entire exercise to the discretion of the agent or distributor.

However, choosing the correct option is perhaps as important to the health of the investment as choosing the particular mutual fund is.

There are two factors that are of prime importance when choosing an investment option. They may be Fiscal policy and Investment needs and goals (of investor).
Both these factors play an important role and how we can derive from each to get the maximum benefit.

Dividend Option – Drawbacks:

Before considering the drawbacks, let us look at the benefit of choosing the Dividend option.

The foremost and the most obvious benefit is that the dividend is tax-free in the real sense of the term. Though all MF dividends are tax-free, dividends received from non equity-oriented schemes are subject to a distribution tax of 14.025%. This means that though such dividend is tax-free the investor receives 14.025% less than what he would have otherwise received. This by inference means that it is the investor who is bearing the 14.025% tax, the MF only pays it on your behalf.

Dividends from equity schemes do not suffer this distribution tax and hence are truly tax-free. Then shouldn’t all investors choose the Dividend option? Not so fast. Let’s take the case of Franklin India Prima, a scheme that has been in existence since November 1993. As on 19th June, 2006, the NAV of the Growth Option of Prima was Rs 153.86 whereas that of the Dividend Option was Rs 48.99 almost 68% lower.

The difference is the dividend received by the investor.
It should be understood that dividend from a mutual fund, unlike stock dividend, is investor’s own money coming back. Therefore, if one had invested in the Growth option of the scheme, the NAV of Rs 153.86 would apply but if the dividend option is chosen, periodically, some of the investment amount was paid back to the investor (by calling it dividend) and hence the market value of units is Rs 48.99.

The scheme performance is calculated based on the Growth option NAV. Technically, it doesn’t matter, which NAV is chosen, as the dividends received are assumed to have been reinvested in the scheme at the Internal Rate of Return or the IRR. But without getting into mathematical jargon, it suffices to say that the Prima performance (which has been nothing less than spectacular) is based on the NAV of Rs 153.86 and not Rs 48.99.
As long as the investor needs the dividend it may not really matter. When the dividend comes and credited in investor’s bank what he can do. Reinvest it in the same scheme or for that matter into another scheme, if so, realize that the dividend money is getting reinvested. The money is in the same asset class — Equity. It needn’t have come out of the asset class (in this case Prima) in the first place! Plus the investor may have to bear a load for the fresh investment. The distributor is happy since this means extra commission.

The second problem is agility. The scheme has paid dividend and the money is lying in investor’s bank. It happens. Even as an investor if you are well aware of the fact, the market is behaving in an unpredictable manner and this volatility is delaying your decision to enter the money again sits in your bank.

All this time, when the money relaxes in your SB account, the rate of return of your investment is falling. The reason is simple arithmetic. The capital that is invested in Prima is growing at the IRR as discussed above (44% for the last year, 69% over 3 years and almost 26% since inception). However, the dividend that is lounging in the bank is growing at just 3.5% per annum which is the SB interest rate. Over time, this substantial difference in the two rates dilutes the net return on the investment. More the time spent in the bank, more the dilution.

There are a couple of excellent reasons given to me by investors for choosing the dividend option. One is of course, needing the funds for day to day life. The second one was that getting dividend in a rising market is like partial profit booking, which is good. The funds representing dividend can be invested into fixed income avenues or even fixed maturity plans thereby rebalancing the asset allocation.

When the interest is fixed, not only in terms of the amount but also the timing thereof, unlike fixed income avenues (such as PPF, RBI Bonds etc.) dividends from mutual funds are at the discretion of the MF. One never knows how much would one receive and when. In other words, the fund manager may decide not to distribute dividend. He may decide to distribute much less than what you need or much more than what your intended shift of the asset allocation dictates.

There is a simple solution. Ask for the dividend yourself. Yes, you read that right. You can ask for the dividend. To put it differently
‘When the MF pays you money, it is called dividend. When you yourself withdraw an equivalent amount, it is called capital gain!
We all know that after one year, withdrawals (capital gains) from a MF are tax-free. Therefore, for your annual dividend requirement, do not depend upon the whims of the mutual fund concerned instead withdraw the funds as per your requirement.
Finally, the psychology of investing, fiscal policy and investor’s requirements from investments, all go hand in hand in deciding the optimal option to choose from. As fiscal policy stands today, the dividend option doesn’t stack up against the alternatives. However, if tomorrow, long-term capital gains tax is imposed, this strategy wouldn’t work and the dividend option would once again come to the fore.