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Choosing the dividend option in equity schemes is counter-productive to long-term investing

LiveMint logoLiveMint 22-03-2017 Srikanth Meenakshi

Should I choose mutual fund schemes that provide dividends from time to time? How are they different from dividends received directly from shares?

—Devagya Pal

Mutual fund schemes typically come in two variants, or ‘options’. There is the growth option and a dividend option.

With the growth option, whenever a scheme’s investments make profits, the profits are either simply allowed to grow or are plowed back into the scheme’s portfolio. Consequently, the net asset value (NAV) of the growth option of a scheme will simply move with the change in the underlying value of the portfolio.

With the dividend option, however, the fund manager has the discretion to ‘book’ profits from the investments and distribute it to the investors in the form of cash. In this case, the NAV of the scheme will keep changing with the underlying value of the portfolio until a dividend is distributed, upon which time the NAV will fall in proportion to the distributed amount.

Please note that the decision to issue dividend is entirely the fund manager’s discretion—there is no obligation to do. Similarly, dividends from stocks are also discretionary. The company is under no obligation to declare dividends at any time, and when they do declare dividend, the amount is entirely dependent on how much profits the company would like to distribute to its shareholders.

In case of mutual funds, the dividend variants of debt funds are more reliable for such purposes. Such funds also have specific variants such as weekly dividend schemes and monthly dividend schemes. However, even in such cases, the amount of dividend distributed periodically could vary significantly between one period and another.

As an investor, one must realize that choosing the dividend option, especially when it comes to equity schemes, is counter-productive to the notion of long-term investing. It simply means taking out profits and not allowing them to further grow—hampering the process of compounding one’s growth in the investment. So, in general, long-term investors would be better-off sticking to growth variants of mutual funds, and allowing their investments to grow as much as they can.

How does the concept of riskometer work, which you see in every mutual funds advertisement? How can I determine in which category I fall?

—Govind Pratap

The regulator of mutual funds, Securities and Exchange Board of India (Sebi), has been trying hard to simplify the way details of a mutual fund scheme get communicated to potential investors. When investors look at a scheme to identify if it is suited to them, they need to have a good sense of what the potential of the scheme is in terms of returns, and what the amount of risk in the scheme is, in terms of volatility and the potential to lose investment capital. The riskometer is an innovation that seeks to communicate the latter—the risk level of a scheme—in a visual form to the investor. It is a statement about the scheme, not about the investor. So, you need not look at the riskometer to figure out which category you belong to. Rather, it should help you understand the particular scheme that you are evaluating.

There are five levels of risk: low, moderately low, medium, moderately high, and high. Certain funds, like liquid funds, would belong to the low-risk category and funds such as sector funds and small-cap funds would belong to the higher-risk categories.

As an investor, you should seek to build a portfolio that fits your profile and investment needs. If you would like to have a blended portfolio of multiple-risk levels, you can do so by using the riskometer to identify the category of the schemes. For example, after you’ve identified a few good funds based on performance, you could see their riskometer labels to see what percentage of your money should go to high-risk funds or what percentage should go to moderate-risk funds. Importantly, the riskometer also serves the purpose of discouraging misselling, since an investor can verify the claim of a sales person by inspecting the riskometer to understand the nature of the product that is being sold.

I have recently started reading about mutual funds investments and am confused with the terms CAGR and expense ratio? How should I read these numbers when I check a fund’s performance? What are the three most essential things I should look for before I shortlist a scheme?

—Rajesh Bhan

Simple put, CAGR, or compounded annual growth rate, is the rate at which your investment has grown over a period of time (or the rate at which a fund has provided returns over a period of time).

Expense ratio is the rate at which you have paid for realizing the growth. For example, if a scheme displays a CAGR of 15% and expense ratio of 2% over the period of a year, it means that the real performance of the scheme was 17% over that period, of which 2% was taken for fund management and related expenses.

As an investor, the most important things to look for while you are looking to shortlist a scheme for yourself are as follows:

First, you should evaluate if the scheme is suitable for you, the time frame of your investment, and your risk profile.

Second, you should evaluate if the fund has performed consistently in the past over multiple market cycles.

Third, you should see if the fund’s management has taken the appropriate amount of risk in the portfolio while delivering those returns.

If these boxes are checked, then it is likely that you have a scheme that would fit your investment needs.

Srikanth Meenakshi is co-founder and COO, FundsIndia.com.

Queries and views at mintmoney@livemint.com

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