Active funds: Why growth option is optimal

If you were to invest in active equity funds for your core (goal-based) portfolios, you have a choice of investing in growth option or income distribution-cum-capital withdrawal (IDCW). In this article, we discuss why you should consider the growth option.

Investment efficiency

An active fund earns returns from two sources — capital appreciation and dividend income. It can choose to distribute the returns to you at periodic intervals or reinvest the gains in the market. If you were to choose the growth option, the fund will reinvest the gains.

If you were to choose the IDCW option, the fund will distribute some of the returns to you at its discretion. You must consider two factors to decide between the two options.

One, the distribution of IDCW is taxed at your marginal tax rate (30%). In contrast, if you invest in growth option and sell the investment after holding period of more than one year, you pay long term capital gains tax of 10% above ₹1 lakh.

Two, when you invest in active funds to achieve a life goal, you must be mindful of reinvestment risk. This is the risk that intermediate cash flows may have to be reinvested at a lower rate. Suppose you expect 12% pre-tax annual return on equity.

Further, suppose the IDCW payments amount to 14%, then you must reinvest the dividends to the extent of 12%.

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The actual calculation is much more involved and depends on the accumulated gains in the portfolio. But suffice it to understand that the responsibility of finding avenues to reinvest is on you; the portfolio manager will find avenues to reinvest in a growth option.

You are still exposed to the risk in a growth option as the fund may not earn 12% on the reinvested gains. But that risk is significantly less because a professional money manager can find better opportunities in the market.

Conclusion

Investing in growth option still requires you to manage your investments. If the actual return on the fund is more than your expected return in any year, you must redeem some units to take out the excess return and invest the proceeds in a bank fixed deposit.

This investment acts as a buffer and will come in handy when your fund investment earns lower-than-expected returns in any year. This argument also holds for your investments in index funds and ETFs.

(The author offers training programmes for individuals to manage their personal investments)