Investing in ELSS – Growth, Dividend Payout or Dividend Reinvestment?

In response to one of my previous post about Tax Savings Mutual Fund (ELSS), I got a query – While investing in an ELSS which option should I choose – Growth, Dividend Payout or Dividend Reinvestment?

This is a question that haunts most of the new/ First time investors. Actually the problem is most of us don’t know the difference between Dividend paid by a Stock & the dividend paid by Mutual Fund. So let me explain this difference first by taking an example.

In the table below we have taken a hypothetical situation of Idea & Fidelity Tax Advantage Fund. Both of them declare dividend of 15% on face value.

As you can see the NAV of Fidelity Tax Advantage is reduced by the amount of Dividend paid by the fund. So in the end you don’t gain anything extra. It’s just your money paid back to you. While in case of Idea you make a gain of Rs. 1.5/share after dividend payout.

Unfortunately most Mutual Funds declare dividend just to attract investors, while truly speaking there’s no gain for investors.

Now that we are clear about Dividend – Let’s see which option is best suited for an Investor in ELSS. Usually if this question was asked for Regular Equity Funds, I would have straight forward recommended Growth Option. But ELSS is a bit different and slightly more complicated product. It has a locking period of 3 Years i.e. you cannot redeem your investment before completion of 3 years. Let’s see one by one what are the pros & cons of these 3 options.

Growth: Here you leave your money to grow and cash out anytime after 3 years. Here the advantage is: Your gains get accumulated till the end without any erosion. So you can get handsome return at end of 3 years. The disadvantage being: There is no cash flow from the investment for 3 years in terms of Dividend.

Dividend Options: There are two sub options in this case

Dividend Payout: In this case the dividend is paid in cash back to you. Here the advantage is: You get some cash flows from your investment before completion of 3 years. But this is unpredictable & erratic and is totally fund’s manager decision. The disadvantage being: The final value of investment gets eroded.

Dividend Reinvestment: In this case the dividend declared is used to buy more units of the same fund for you. But in ELSS the problem is every time a unit is purchased you can redeem it only after 3 years. So if you initially invested on 1st Jan 2010 and dividend is paid and reinvested on 1st Feb 2010 then you cannot redeem the dividend reinvestment units before 1st Feb 2013. This Dividend Reinvestment is considered at par with fresh purchase for all purposes. I don’t see any reason why anyone should choose this option.

To conclude:

I personally prefer Growth option for all my Mutual Fund Investments as it lets me build a sizeable corpus at the end without any erosion in between. Most of the times when we get dividend, we splurge it without even thinking of reinvesting.

But there may be situation where you need some cash flows from your investment and don’t want to wait for 3 years, then go for Dividend Payout. But always keep in mind the dividend declaration is totally fund manager’s prerogative. You cannot predict how much you would get and when. So it hardly helps!