Is dividend option in NFO a smarter choice?

What's better -- the dividend option or the growth option? That's one question, which investors regularly pose to us. In the case of an equity fund, so long as both the options have the same portfolio, they are at par (on rare occasions, some funds have different portfolios for the growth and dividend options).

Hence, investors should make their choice based solely on their need for liquidity. Despite dividends not being assured, if liquidity is critical for the investor, he should opt for the dividend option; else, the growth option should be the preferred choice. While the growth option offers compounding benefits, the dividend option offers liquidity.

However, this seemingly simple concept is often lost on investors. And more often than not, it is the significant amount of misinformation which is to blame. For instance, in the past, a "forthcoming dividend" was used by fund houses and advisors alike as a marketing ploy to garner fresh monies. The dividend was declared well in advance and then heavily publicised to lure investors to get invested in the fund.

Of course, no one bothered to inform the investor that the fund's net asset value subsequently falls to the extent of the dividend declared. In effect, the investor is simply paid a dividend out of his investment corpus i.e. the dividend is not an additional benefit.

To stem this malpractice, the Securities and Exchange Board of India introduced norms for dividend declaration (in April 2006). Fund houses now have to declare dividends i.e. communicate the same to investors along with the record date in a particular format, a day after getting the go-ahead from the Trustees.

The record date for the dividend is five days from the date of notice. Most importantly, fund houses are required to clearly mention that the NAV will fall to the extent of the dividend.

This brings us to another popular misconception about dividends, especially in new fund offers (NFOs). It is widely believed that opting for the dividend option in an NFO makes a good investment proposition. The reason -- units in an NFO are issued at Rs 10. As a result, the investor in an NFO is likely to end up with more units as compared to a similar investment in an existing fund (that is likely to have an NAV higher than Rs 10).

And more units would typically translate into a higher dividend payout. As a result, often investors are advised to dump existing funds in favour of an "NFO-dividend option" combination. An example will help us better understand the same.

The NAV-dividend trade-off

As can be seen in the table above, despite investing the same amount, the investor acquires more units by investing in an NFO as compared to the existing fund. And since the dividend payout is linked to the number of units held, the former becomes a more lucrative option. Correct? Not quite! In fact, this argument is fundamentally flawed on several counts.

1. First, let's not forget that dividends are distributed by funds subject to availability of a distributable surplus. Simply put, a fund needs to collect and invest monies, clock a healthy return and then make provisions for redemptions and future investments.

Only subsequently if the finances permit, will the fund be equipped to distribute a dividend. It can be safely assumed that an existing fund with a proven track record has already passed through this learning curve; conversely, an NFO is yet to begin. This in turn has two implications. One, the NFO is unlikely to be equipped to declare a dividend in the near term. Two, if and when it does, it will take a while before the NFO can match the dividend declared by an existing fund. Clearly the lower NAV-higher dividend theory doesn't necessarily hold good.

2. Second, the NFO is an untested entity. Unlike an existing fund wherein investors can fall back on a proven track record, investors have no means to evaluate an NFO's worthiness. Critics might point out that even in an existing fund, the proven track record need not translate into a good showing in the future, and rightly so. But then it can certainly provide an insight into the fund's investment style and aspects like its propensity for declaring dividends. The higher risk while investing in an NFO is indisputable.

3. When an investor starts considering an investment proposition like "dividend option in an NFO", he runs the risk of making an investment from the wrong perspective. While investing, the first step should be selecting the right fund, followed by choosing the right option. So ideally, there is a need to assess if the NFO fits into the investor's investment portfolio and then the rest should follow. Starting off with a preconceived notion like "dividend option in an NFO" may lead to getting invested in the wrong fund and the wrong option as well.

What should investors do?

For starters, keeping things simple would be a good idea. Don't fall for gimmicks. Instead, evaluate the investment proposition offered by a fund and find out if it fits into your portfolio. And if it does, then select the option i.e. growth or dividend based solely on your need for liquidity.

On a closing note, some unscrupulous relationship managers from fund houses are known to leak information about forthcoming dividends, in contravention of the SEBI guideline. Advisors in turn use this information to entice investors. Perhaps it's the clandestine nature of the event that impresses investors and convinces them to get invested. At the risk of sounding repetitive, if you find yourself in such a situation, do not forget that the dividend on offer will only be paid out of your investment corpus.

Hence, it's just a case of 'Robbing Peter to pay Peter'.

Make the most of Sebi's "zero entry load" guideline. Read on.