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How to pick the best mutual fund scheme

By Hemant Rustagi
Last updated on: December 01, 2005 09:35 IST
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Selecting the right mutual fund, especially in the equity segment, is a challenge.

But, deciding which option to go for (dividend payout, dividend reinvestment, growth option) is as critical. Let's work on that.

Equity funds - Growth option

Under this option, no dividend is declared and the Net Asset Value moves up and down depending on the market movement.

You end up paying tax only when you sell your units. The rate of tax depends on the period for which you held the units.

Let's say you sold your units (redeemed them) within 12 months of buying (date of investment). You will have to pay short-term capital gains. This is a flat rate of 10%.

If you redeem the units after 12 months, you will have to contend with long-term capital gains. As per the current tax laws, this is nil.

While most investors may be clear about this, they are unsure about the right time to book profits (sell your units at a profit). And, it is essential to sell to rebalance your portfolio to the original asset allocation.

Asset allocation is a method by which one decides the percent of total investments (exposure) to different asset classes such as equities (shares) and debt (fixed-return).

So, when the value of your equity funds grows over a period of time, your exposure to that asset class increases.

Remember, 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 (exit) 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 growth option.

Equity funds - Dividend payout

Under this option, the fund declares a dividend as and when it has surplus money.

As per the current tax laws, dividend declared by equity and equity oriented funds is tax free in the hands of investors.

An important highlight of this option is that any dividend received within 12 months from the date of investment, a part of the short-term capital appreciation, is converted into tax-free income.

For example, assume that the NAV of a fund grows from Rs 10 to Rs 14 after seven months and the fund declares a dividend of Rs 3 per unit. This will convert 75% of the short-term gains into a tax-free income.

If you had to sell your units, you would have had to pay tax. But when you get a dividend, you don't.

Another major advantage of this option is that it allows you to book a profit at different levels without having to bother about the right or wrong time to do so.

Considering the tax laws and the automatic rebalancing of portfolio, this certainly can be a better option.

Equity funds - Dividend reinvestment

Under this option, the fund declares a dividend and reinvests it into the fund.

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 one that scores?

To avoid the market timing, one can opt for dividend payout and reinvest the dividend amount in an equity fund through a Systematic Transfer Plan.

A STP allows you to transfer a fixed sum at pre-determined intervals, from one fund to another. So, you may have some money invested in a floating rate fund and you can opt for a STP whereby the money will move to an equity fund of the same mutual fund house.

If the amount is not sufficient to enroll for an STP, some additional contribution can be made.

Debt funds

These are funds that invest in fixed-return instruments.

In the debt and debt oriented funds, it is beneficial to opt for the dividend option for an investment made for less than one year.

On the other hand, it makes sense to go for the growth option for investments that one intends to keep for more than one year.

When a debt fund declares a dividend, there are certain tax implications.

As per the current tax laws, mutual funds are required to pay:

Dividend distribution tax: 12.50%
Plus Surcharge: 10% on the tax
Plus Education cess: 2% on the total of the above two

This is for individual investors. If it is a corporate, then the dividend distribution tax increases to 22.44%, while the other two stay constant.

But, it is important to note that dividends are tax free in the hands of investors.

On the other hand, long-term capital gains are taxed at 10% for every investor, irrespective of the category he falls under.

The short-term capital gains are taxed as per the applicable slabs for individuals. In other words, the gain is added to the income and according to the tax bracket the individual falls under, he is taxed.  For corporates it is 30%.

As is evident, each of these options have positive and negative implications. The key is to select the right option keeping in mind the type of fund, tax incidence, investment objectives and time horizon.

The author is CEO, Wiseinvest Advisors Pvt. Ltd, a mutual fund advisory firm.


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Hemant Rustagi