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Take a cursory glance at any mutual fund advertisement, and there's a fair chance it's either for a new fund offer or a forthcoming dividend. In fact, advertisements flaunting tax-free dividend figures (at times as high as 150 per cent) along with the record dates has become commonplace. Investors are drawn towards these schemes by the prospect of earning an instant return. In our view, this is yet another instance of investors getting invested for the wrong reasons.
To understand this phenomenon, we first need to understand what the various options like dividend and growth are, and how they work. While investing in a mutual fund scheme, investors can opt either for the growth, dividend or dividend reinvestment option. Under the growth option, the onus of booking profits (by way of redemption) lies solely on the investor. Selling of units results in a decrease in the number of units held by the investor with the net asset value remaining unchanged.
Conversely, in the dividend option, the investor is entitled to receive dividends (if any) declared by the fund house. However, a dividend declared results in a corresponding fall in the fund's NAV. Effectively, the dividend received from the fund house is set-off by a reduction in the fund's NAV.
Within the dividend option, there is a dividend payout option and a dividend reinvestment option. Under the dividend payout option, the investor receives a dividend cheque. Under the dividend reinvestment option, the dividend is reinvested in the fund. Consequently, the investor has more units at his disposal every time a dividend is declared, but the NAV witnesses a depreciation. Clearly, there is very little differentiating the various options in terms of a return.
However, fund houses and investment advisors seem to think otherwise. Dividend declaration has turned into a major selling opportunity. The same is used to peddle schemes and mobilise net assets. Our objection to this phenomenon stems from the following factors.
Firstly, the investor could land up with a scheme that is wrong for him. If the basis of investing in a scheme is flawed, so is the investment. To make matters worse, the investor might also select the wrong option. The dividend option is suited for investors who need liquidity at regular intervals. If liquidity is not of prime importance, the investor is better off with the growth option.
Furthermore, when a fund declares a hefty dividend, it can be indicative of the fund's desire to distribute the gains clocked with investors. Alternately, it might be a sign of the fact that the fund manager doesn't see any attractive investment opportunities. If the latter is true, investors would certainly not like to be associated with the fund.
Secondly, the expense incurred on advertisement campaigns for spreading the word about dividends is ultimately borne by investors. These expenses form a part of the marketing expenses, which are charged to the fund. The fund's NAV is declared after expenses have been factored in. On the other hand, lower expenses will translate into higher returns for investors.
The dividend option has its fair share of advantages and disadvantages. For example, in case of a downturn in markets, investors with the dividend option would have returns to show for by way of dividends received earlier. Conversely, in case of a long-term investment (which is the norm for equity investments), the growth option enables investors to enjoy the benefits of compounding. This is where investors in the dividend option would miss out.
Our advice for investors - invest in a fund because it makes a good fit in your portfolio and can help you achieve your financial objectives. A forthcoming dividend doesn't qualify as a good reason for getting invested. Also choose between various options like growth and dividend based solely on your need for liquidity.
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