Monday, March 12, 2007

Which Option would you opt for?

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Back to the taxing question with a bang – Which Option would you opt for?

Asset allocation is a method by which you decide the percentage of total investments to be made in different asset classes such as equity and debt. So, when the value of your equity fund grows over a period of time, your exposure to that asset class increases. The key to success in equity investing is to book profits periodically, even if you are a long-term investor. Undoubtedly, the growth option can be described as the best as it advocates long term investing. However, investors have had mixed experiences over a period of time. There have been occasions when investors have sold their units only to see the NAV scale greater heights. Or, they may exit in panic when they see the NAV spiral downwards. Therefore, deciding the right time to rebalance, is a challenge for those who opt for the growth option.

The dividend payout option, allows you to book a profit at different levels without having to worry about the right or wrong time to do so. If you are nearing your retirement, have a low investible surplus, or are uncomfortable with volatility, you are better off opting for the dividend option. In doing so, you get to book profit periodically and divert the dividend amount into safer investment avenues. A dividend payout option may also be a good idea in the case of mid-cap funds or theme funds where the bulk of the returns are earned in short periods. But do not rely on the dividends as a source of income, as declaring dividends is completely at the fund's discretion.

Mutual funds can declare dividends only out of realised profits (less unrealised depreciation in the portfolio, if any). Therefore, the advantage of dividend reinvestment option is that, effectively, you would be booking profits and reinvesting it without paying either capital gains tax or STT at the time of investment (assuming the investment is made in an equity-oriented fund). On reinvestment, no entry load is payable and, therefore, there is no additional cost to you. Capital gains taxation on the dividend reinvestment portion arises only if it is sold within a year. Your cost of acquisition is higher than what it was at the time you entered the scheme, thereby, lowering the gains. This lowering of gains also applies to the gains that you made on the units you had purchased initially. This happens because your initial gains were paid out in the form of dividends. Basically, what a dividend re-investment option does is to convert your capital gains into tax-free dividends and then allow the capital gains to generate gains again. It is only when you book profits or exit a scheme that the gains are subject to tax. So, in effect, although you have made gains twice, you end up paying taxes just once. But the point to be noted is that the entire tax-free dividend amount is reinvested on a particular day, which in a way is timing the market. Considering that timing the market is not a strategy that works all the time, re-investment option may not prove effective at all times. The time it takes to receive dividends and redeploy them, can be better spent by keeping the funds invested. Added to this is the dilemma for finding good opportunities to invest in.

It is against this backdrop that I intend to lead you to the option that will enhance your post-tax returns.

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