Know Your Options

Mutual funds have emerged as a very useful and tax-effective vehicle for investors with different risk profiles and time horizons. The added advantages are the variety of options, flexibility, and the simplicity with which one can invest in them. It is, however, imperative that proper care is taken at the time of making an investment.

If one follows certain basic principles of mutual fund investing, the chances of success improve considerably. Besides, having the right allocation in equity and debt funds helps in achieving different investment objectives over varying time periods.

Over the years, the principles and techniques of investing in equity funds have undergone a sea change. One of the key decisions that investors are required to make is to select the right option in a scheme. There are three options for those who invest in equity funds - dividend payout, dividend reinvestment and growth option. Knowing which is which and knowing what you should go for is important.

First let us understand the ‘growth option’. Under this option, the fund does not declare dividend and the NAV is allowed to grow. The tax incidence under this option depends on the period for which the money remains invested. As per the current tax laws, short-term gains, i.e. gains made on investments redeemed within 12 months, are taxed at a flat rate of 15 per cent. Long-term capital gains, i.e. gains on investments redeemed after 12 months, are not taxed.

There have been occasions when investors have exited from a scheme only to see the NAV touching new heights and also occasions when the NAV of the fund has spiralled down, thereby taking away a majority of the gains. While the growth option can be described as the best option as it offers compounding benefits, in reality, investors have suffered as and when the markets have taken a beating. However, for a small investor who wants to build a capital over time through systematic investing, growth options remains a better choice as the fall in the value can be offset to an extent by investments made at lower levels.

‘Dividend payout’ is an option under which the fund declares dividend as and when it has surplus. As per current tax laws, the dividend declared by equity and equity-oriented funds is tax free in the hands of investors. An important highlight of this option is that any dividend declared by the fund within 12 months of investments made converts a part of short term capital gains into tax-free income.

Equity investing requires investors to follow a disciplined approach as well as re-balance the portfolio periodically to bring the current asset allocation closer to the original level. Therefore, the right way is to go for the dividend payout option wherein the fund manager distributes a part of the gains as a tax-free dividend. This in a way  ensures that you, as an investor, stand to receive dividend from time to time as well as book profits without having to worry about the right or wrong time for doing so.

Now let’s understand the ‘dividend reinvestment’. While the first part, i.e. dividend payment is exactly on the lines of dividend payout, the end result completely differs as instead of paying the dividend amount to investor, it is reinvested in the same fund. While this option has the combined features of dividend as well as growth option, it negates certain advantages. For example, while the profit is booked by way of dividend payment, the same is reinvested in the fund at the same market level thereby defeating the main purpose.