Growth Strategy vs Dividend reinvestment Strategy

  • Dec 10, 2019 GMT
  • Team Kalkine
Growth Strategy vs Dividend reinvestment Strategy

Of the different portfolio strategies in investment management, the most prominent is the Growth investment strategy. An active investment strategy, this strategy entails choosing stocks of high performing companies who are either in their early stages of development or mid stage of development and are faced with immense growth opportunities. These companies are investing heavily in themselves to benefit from such opportunities. These companies offer high risk high reward potential and a portfolio based on such stocks, more often than not employ some very talented fund managers and the employment of very complex analytical tools to aid through the entire investment decision making process.

By the very description of this strategy, it might sound that this strategy would be giving good returns if not astonishingly high, but the reality is that they more often than not provide returns that are marginally better than the returns of the benchmark index. The downside is that the funds implementing this strategy charge hefty fees for the manpower and the tools deployed for asset management. Given the above, one might wonder if there exists any other strategy which would not be so expensive yet offer a similar return potential and that too with lesser risks undertaken. Well there is one strategy, not an active one but a semi-passive one called the Dividend Reinvestment Strategy which, if pursued in the middle to long term with discipline, offers returns potential similar to that of an active growth strategy  albeit with a far smaller risk profile.

The Dividend Reinvestment strategy is a development over the Passive dividend strategy. As the name suggests the Dividend strategy deploys passive fund management which entails buying and holding stocks of large, established companies which are least effected by the ups and downs of economic cycles and have a consistent record of payment of dividends. The dividends earned by the funds employing these strategies are distributed to the investors and are usually the only source of income for them as these funds do not target capital gains as their primary source of earnings.  The strategy requires lower portfolio churning, requiring less management personnel and deployment of less sophisticated analytical tools with the result that it is less expensive to operate. The strategy is suitable for such investors who have a large corpus of funds at their disposal with little to no deployment opportunities and who are in the later stage of their lives and care more about a large current income, rather than investing for the middle to long term for the sake of capital gains. The returns generated by the funds who deploy this strategy is usually low and maybe only marginally higher than the income derived from a portfolio of fixed income securities. However, this is also subjective as in times of economic downturn dividend yields may come down making the returns generated by such funds to fall below that of fixed income portfolios.  The most appealing factor about these funds is their capital preservation factor; since these funds invest in large established companies, which usually have a very good reputation in the market, they offer the highest safety feature among all equity portfolios and instill confidence among investors.

In dividend reinvestment strategy, the investment income does not get paid to the investor and is redeployed for a mid-term to long term with growth and income perspective. It is in a sense an advancement over the dividend income passive investment strategy and involves active management of portfolio. In this strategy the portfolio manager first chooses companies which are currently in a growth phase but are sooner to transition into a flatter growth trajectory and distribute their earnings in the form of dividends. Once these companies start paying dividends, these dividends are redeployed by the fund manager, which over a period of time increases the size of the fund and the investment portfolio of the investor. This portfolio, while initially not distributing any income to the investor, becomes a huge corpus with progressive redeployment, with the result that in the mid to long term the dividend yield and capital gains earned by the investors is very large compared to the original investment amount of the investor. The risk involved in these strategies is also very low compared to an active portfolio strategy, as active redeployment of dividends often takes the income yield higher with the actual rate of dividend payout remaining as it is. The pure dividend strategy is suitable for wealthy and middle-aged to senior investors while this modified dividend reinvestment strategy is suitable for people who are young and at the start of their careers. This strategy requires them to part with a small part of their current income initially when they are the most able to assume risk in their lives, with the risk profile decreasing with the passage of time and income potential increasing significantly in the middle part of the lives and careers when current income starts to become more important to them. These funds will start giving them higher income yields with the additional benefit that their large portfolio sizes will attain immense capital gains potential as well.

There are several Exchange Traded Funds (ETFs) and mutual funds that are in operation today and deploy this investment strategy. This type of an ETF has other type of advantages similar to that of an actively managed ETF as well. These funds, while consistently investing in dividend paying mid-to-low risk stocks, have less overall volatility and are much better placed to withstand adverse economic shocks and preserve investors’ wealth. These funds are able to successfully deploy time as a factor to bring down the risk associated with investments and in the long run the investor not only realizes a good capital gains return but also a current income that is far superior to a traditional pure passive dividend ETFs. The above is a powerful long-term growth strategy and it has the potential to not only surpass the both active and passively managed funds in terms of returns but also acts as preserver of investors’ wealth. The performance of this type of fund mimics a forward inclining curve, which in the initial years would seem to underperform but will slowly and steadily rise and in time surpass other comparative funds, while an actively managed fund may show a good performance in the short term but its growth may stagnate in the mid to long run.

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