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Dividend option or growth option - Which is better? - Outside View by PersonalFN
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Dividend option or growth option - Which is better?
Mar 15, 2011

"Exuberance is beauty", said Mr. William Blake - a famous English poet, painter and printmaker.

And probably getting inspired by this famous quote, most of the financial markets of the world have also tried displaying "financial exuberance". But unfortunately, it isn't really beautiful as the famous poet - Mr. Blake said it.

Today, complex financial products are being launched as financial innovation is being experimented. And apparently the exuberance of financial innovation so immense that the financial engineers too aren't very clear about the product they launch, and their implications in the long-term. But interestingly to make it simple and lucid (which it never is!), the marketing team (along with the product team) takes every effort to persuade you to fall for this financial exuberance. And interestingly many of you too fall prey for this exuberance without assessing whether it is meant for you.

Let's take the case of mutual fund investing. With so many options such as dividend payout, dividend re-investment, growth and bonus, provided by mutual fund houses while investing in mutual fund schemes, many of you aren't even aware how each of these options work, and which is the most suitable option for you.

It is imperative that before you signify your choice of option, you are aware what they mean and how they function.

  • Dividend payout option - This option proposes to timely pay distributable surplus / profits to you in the form of dividends (either through cheques or ECS (Electronic Clearing Service) credits), thereby facilitating you to liquidate profits.

  • Dividend re-investment option - Under this option instead of paying dividend cheques or providing ECS credits, the dividend amount declared by a mutual fund scheme, goes in buying additional units of the same scheme (where you are invested), and you continue to book profits and keeps re-investing them in the same scheme.

  • Growth option - Under this option, you do not receive any dividends. Instead continue to enjoy compounded growth in value of your mutual fund scheme, subject to the investment bets taken by the fund manager.

  • Bonus option - Under bonus option you are not paid regular dividends. Instead you continue to receive bonus units in accordance to a ratio declared by the fund house. (very few mutual fund houses have this option)
Now as far as question of which is the correct option is concerned, it depends upon what your financial plan calls for. Your financial plan drawn by your planner should ideally be a function of your age, income, expenses, nearness to goals and risk appetite.

So say if you are young, your income is higher, your commitment towards certain expenses are lower, your willingness to take risk is high and you are many years away from your financial goals; then you may opt in for the growth option (while investing in mutual funds). And remember at a young age, since one generally doesn't look for a regular cash flow (as generally a regular income flows in the form of earnings), one should ideally opt in for the 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). Dividend re-investment option is just another financial exuberant option provided by mutual fund houses.

But very often many of you do not take into consideration these aspects, and are under a common misconception that the "dividend option is always better", since it provides better returns due to the dividends declared. This is because you feel that you'll fetch better dividend adjusted returns, as compared to the returns in the growth option. But the question is, have you assessed whether it's true?

  HDFC Top 200 (D) HDFC Top 200 (G)
NAV Date NAV (Rs) Dividend % Cash Flow NAV (Rs) Cash Flowh
7-Jan-00 25.81   (10,000) 25.04 (10,000)
24-Mar-00 24.81 25 969 24.9 -
25-Aug-00 16.03 21 814 16.03 -
23-Feb-01 13.84 20 775 15.87 -
15-Mar-02 12.44 20 775 16.46 -
31-Oct-03 19.90 25 969 33.20 -
8-Mar-04 21.96 15 581 41.92 -
15-Dec-04 24.07 30 1,162 49.35 -
17-Feb-06 36.31 45 1,744 85.04 -
7-Feb-07 42.97 50 1,937 1,14.81 -
7-Feb-08 48.13 50 1,937 145.51 -
5-Mar-09 23.36 30 1,162 78.87 -
11-Mar-10 46.58 40 1,550 180.11 -
8-Mar-11 48.18   18,668 203.84 81,405
Returns (CAGR) 16.80% 20.60%
NAV as on March 8, 2011
(Source: ACE MF, PersonalFN Research)

The table above explains that if one were to invest Rs. 10,000 in the HDFC Top 200 Fund on January 7, 2000 in the dividend and the growth option each, at an NAV (Net Asset Value) of Rs. 25.81 & Rs. 25.04 respectively, and were to stay invested for a period of 11 years; the return on investments would be only 16.8% under the dividend option, while 20.6% under the growth option.

This thus indicates that opting for a dividend option does not always give better returns, when compared to growth option.

Also, many of you are often under the illusion that, after the dividend record date the NAV would not be impacted - meaning it will not fall. But please recognise that the fact is, it does drop to the extent of the dividend declared by the fund, plus due to the downside volatility it is exposed to. Interestingly many individuals also very erratically compare the NAVs of the "dividend option" (especially while the markets are on an upswing) with the NAV of the "growth option", and wonder why it is lesser than the other. Please recognise that in case of the growth option, the NAV paves its way with the market movement and the other expenses which the fund is exposed to.

However, this seemingly simple concept is often lost on you. And more often than not, it is the significant amount of misinformation and financial exuberance which is to blame. Some fund houses in order to garner more AUMs (Assets Under Management), in the past have attracted investors by declaring enticing dividends and their marketing teams have also cashed-on this (and they still do!) by giving fancy ads.

But now, as SEBI (Securities and Exchange Board of India) has proposed norms which bar mutual fund houses from tapping the unit premium reserve account and instead declare dividends from realised gains (i.e. profits booked in the event of upswing in the markets); the quantum of dividends is expected to reduce. In fact at present some mutual fund houses have even held back their plans of declaring hefty dividends.

What should you investors do?
Remember, while your agent / distributor / relationship manager may give you the dividend track record of a mutual scheme and try to display financial exuberance, it may not carry much relevance now (in context of the new norms proposed for dividend declaration). Hence while selecting between the dividend option and growth option, see what suits your financial plan / needs primarily. If you are looking at the benefits of compounding then you should ideally opt in for the growth option. Whereas, if you are looking at regular cash flows (in the form of dividends) or want to book profits at regular intervals, then you may consider the dividend (payout) option while investing in mutual funds.

While exuberance may seem beautiful for the manufacturers and distributors of financial products, in our opinion you really need to evaluate whether it really suits your need and whether its adds beauty to your investment portfolio.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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