The Hindu Business Line : Dividend or growth option: No easy choice

"THE fund I bought five years ago has doubled in value over the past year. Should I book profits or stay invested?" This is a dilemma that investors in equity funds face quite often. Yet it is not easy to resolve; for how do you decide when to book profits on your fund?

Do it too early and you may have the mortification of seeing your fund's NAV rising by another 50 per cent after you exit. Leave it too late, and the value of your investment may be shaved off by a third, following a sudden dive in stock prices!

One way out of this dilemma would be to invest through the dividend option of an equity fund. Investors have traditionally decided between the dividend and growth options based on their relative tax efficiencies. But "dividend versus growth" may be an important strategic decision as well.

An analysis of dividend payouts by funds over the past seven years shows that large dividend payouts by equity funds have usually proved to be good "sell" signals to investors, allowing them to book profits at the right time.

In what circumstances should you opt for the dividend option and when should you go for growth?

Growth for the long term

If you plan to stay with your fund for a long time, the growth option may generate vastly superior returns to the dividend option. The growth options of the leading equity funds have beaten the dividend options by a large margin, if you started investing in June 1998 and have held on for the past seven years.

The gap between growth and dividend is particularly high for the top-performing funds. The growth options in funds such as the Franklin India Bluechip, Alliance Capital Tax Relief and Franklin Prima Fund have delivered annual returns that are a good 7-11 percentage points higher than that on the dividend options (all calculations assume that the investor has been investing the dividends received into a liquid fund, earning 4.5 per cent per annum).

But these results do not give you the full picture, influenced as they are by the high stock market levels prevailing now. In the raging bull market of the past two years, equity funds have outperformed all other investment options by a big margin. Thanks to this aspect, any investor who chose to cash in on his gains in the form of dividends would have lagged far behind the one who stayed invested through the growth option.

Not a consistent trend

How has the dividend option fared vis-à-vis growth over various market phases? Not too badly, it turns out. Even for the top-performing funds, the growth option has not outperformed the dividend option with any degree of consistency over the seven-year period.

For instance, if you split your investment equally between the dividend and the growth options of the Franklin India Bluechip Fund in June 1998, and checked on your investment every day, your investment in the former would have been worth more than that in the latter, about 45 per cent of the time!

The growth option has been even less consistent in some other funds. Dividend has outperformed growth about 67 per cent and 80 per cent of the times respectively in Alliance Capital Tax Relief and Birla Advantage Fund.

Returns from growth tend to trail those from dividend in the initial years of investment, especially if you invest in a bull phase. But if you wait out the volatile phase, and allow the stock market to revive, the growth option has raced ahead of the dividend option.

Dividends as a "sell" signal

If the dividend option has fared better than you would expect, this is because big dividend payouts from funds have usually been well-timed. Liberal dividend payouts usually precede declining or flat trends in stock prices, making it an opportune time to cash in on your investments.

Most equity funds declared generous dividend payouts in March 2000, helping investors cash in on part of their profits on equity funds just ahead of the tech-stock led crash of 2000-2001.

The 300 per cent dividend payout by Alliance Capital Tax Relief in March 2000 preceded a 30 per cent decline in the fund's NAV in the year that followed. Similarly, HDFC TaxSaver's 210 per cent dividend in April 2000 helped investors book profits on their fund ahead of the 21 per cent decline in NAV over the subsequent 12 months.

Differing dividend policies

Fund-houses differ widely in their dividend policies. Alliance Capital pays out liberal dividends on its equity funds in bull markets; but usually refrains from payouts in the dull years. Others, such as Franklin Templeton, Birla Mutual and UTI Mutual, vary the dividend quantum but rarely skip a year.

Even equity funds that follow a consistent dividend policy tend to step up their payouts during a bull market. Several equity funds, for instance, declared big payouts in end-2003, when the Sensex breached the 6000 levels. Fund-houses also time their dividends to beat tax deadlines. But there may be fewer such occasions in the future as the tax advantage of dividends relative to long-term capital gains has been whittled down over the years.

When to opt for dividends

These trends suggest that the dividend option would be suitable for you in the following circumstances:

If you plan to remain invested in an equity fund for a shorter investment horizon of say, less than five years or do not know when you may require cash, the dividend option may be more suitable than the growth option.

When you invest in the latter, making an early exit may involve a sacrifice on returns. By investing through the former, you can cash in on returns as and when they accrue during your holding period. Even if the stock prices do enter a moribund phase at the time of your exit, you will still have the dividend receipts to tide over your liquidity requirements.

If you are a conservative investor, who has a low tolerance for sharp swings in the value of your investment, the dividend option will suit you far better than growth. Periodic dividend payments will help reduce the proportion of your portfolio that you have invested in the equity fund and you can periodically plough returns into safer investment avenues such as a liquid fund.

Investors who are close to retirement or those with a small investible surplus should probably opt for dividends over growth, if they decide to invest in equity funds. And that decision would have to taken carefully as most investors may not be able to absorb equity shocks in a post-retirement phase.

If you financial goals may require periodic infusion of cash from your investment, opt for the dividend option.

If you are investing in a mid-cap fund or a theme fund, where returns are likely to be more volatile than in a diversified fund, going for dividend may be a better option than growth. Returns in such funds may largely be generated in short periods. Booking periodic profits on your investment may help you lock into periods of good performance.

The converse is true for the growth option. Opt for the Growth option if:

If you are saving towards long-term investment goals such as your children's education and are unlikely to pull out money within the next five years. The value of your investment in the growth option may suffer sharp blips in value as you hold, but if you wait out these periods, the return may add up to a substantial sum at the end of your holding period.

If you are an aggressive investor who does not mind higher volatility, but seeks high returns. The compounding effect will ensure that the growth option delivers far higher returns than other investment avenues over a longer holding period.

Dos and don'ts in making a choice

WHILE making your investment decision on equity funds, try and factor in the following:

Do not depend on dividends from equity funds to meet your regular income requirements.

Equity funds can declare dividends only when they book profits on the stocks held in their portfolio. Even fund houses with a consistent dividend policy may skip dividends for a year or two, if the stock markets enter a moribund phase.

Be prepared for considerable variation in the quantum of dividend from year to year.

Do not use dividends as the sole measure of a fund's performance. Remember, your returns from the fund are a sum total of the dividend and any capital appreciation on the NAV. One is no good without the other.

Beware of funds that advertise their dividend declaration to attract new investors. Dividend payouts make no difference to the returns from an equity fund. The NAV of the fund declines to the extent of the dividend. Avoid investing in funds based on an imminent dividend payment.

Be sure to sweep all the dividends from your equity fund into a short-term savings instrument as and when you receive them.

Pulling any money out of a stock market investment usually involves an opportunity loss.

If you let the dividend receipts idle, this may significantly reduce your returns from a dividend strategy.

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