Dividend Funds or Growth – Which is a Better Option

After reading enough online material on personal finance and the benefit of participating indirectly in equity markets Abhishek, aged 34 made up his mind on investing in mutual funds. He earns around Rs 60,000 as take home salary per month. So he plans to start up a SIP of Rs 5000 and invest Rs 1,50,000 lump sum in mutual funds. Dividend funds or Growth ??? Confused ?

The dividend funds option aims at paying periodic dividends to the investor provided the fund has earned returns. The growth option provides long‐term capital appreciation to the investor which can be realized at any time the investor chooses.

Dividend Funds or Growth?

An investment option is usually chosen on a random basis. Some people prefer to receive dividend periodically, while others like recurring investments and hence go for reinvestment options and some others prefer growth. Therefore, choosing the right option is important to the health of investment.

But after deciding the right financial instrument to invest, he still finds himself confused when his agent asked him whether he want to choose growth or dividend funds option while filling up application form.

Three Options for Investor

  • Growth,
  • Dividend and
  • Dividend re-investment option

We will analyse each of these options. There are a lot of misconceptions about these three options and the agents never bother to discuss it with the investor while deciding which fund to choose.

Dividend Funds or Growth

How does a growth option work?

When you select a growth option of mutual funds, all the profits and losses made by the fund manager are reflected in the NAV of the mutual fund scheme. If the mutual fund gains, NAV goes up and vice versa. The investor can realise profits only by selling his mutual fund units but the mutual fund scheme doesn’t distribute profits.

Example: If a investor has bought Reliance Growth Fund at a NAV of 200. If after 5 years, he finds his NAV at 440, it means he has made 120% returns in 5 years.

How does dividend option in mutual fund work?

Lets understand how dividend option in mutual fund works. This will give you a sense that you don’t gain or lose per se by selecting any one of the two options. If you choose a growth option of mutual funds, you will get capital gains and you will earn money by compounding effect when you will sell units at a higher NAV. But in dividend option, you will enjoy both capital gains and dividend but the amount of capital gains may not similar (may be lesser) to capital gains realised in growth option of mutual funds.

Example: If you have 100 units of HDFC Equity Fund at a NAV of 50 under dividend option. The fund manager decides to declare annual dividend under the scheme of Rs 3 per unit. The investor will get Rs 300 (3*100) as dividend and the NAV of HDFC Equity fund would get decreased by a similar amount of Rs 3 per unit. Don’t think that the dividend income which you receive is something extra which you don’t get in a growth option.

How does a dividend reinvestment option work?

Under dividend reinvestment option, dividend is distributed periodically is used to buy the units of same mutual fund scheme and you get more number of units. This is quite similar to the concept of growth option where your objective is capital appreciation, not earning yearly dividends.

Example: If you have 1000 units of SBI Emerging Business Fund at a NAV of 100, total investments being valued at Rs 1,00,000. Dividend declared by the mutual fund scheme is Rs 10 per unit (10%).

You will get a dividend income of Rs 10000 and the NAV of SBI Emerging Business Fund falls to Rs 90 per unit. Now, Rs 10000 which you got as dividend would be re-invested back to the fund and you will get additional 111.11 units and now you will have a total of 1111.11 units, each unit valued at Rs 90 and total amount of investment being Rs 1,00,000.

Impact on NAV

The NAV of growth option would always be higher or equal to NAV of dividend option (NAV equal in case the mutual fund scheme has not declared any dividends yet) because in case of dividend option, part of the profit is distributed among the investors as dividend income where as in growth option, the money once invested remains in the scheme until and unless he fill the application to withdraw the money.

When to choose Growth option?

If you are investing in equity markets directly or indirectly, you can’t forgo the advantage of compounding effect which takes place in growth option of mutual funds more effectively.

Example: An annualised return of 18% makes your money 5.2 times in 10 years and 27 times in 20 years which is possible only when you choose growth option buying filling mutual fund application form.

If you are earning well and running through the phase of wealth accumulation and doesn’t require regular income, then growth option should be the best suitable option for you and take the benefit of power of compounding which may not take place in dividend payout option.

Risks involved: Every penny invested in equity markets directly or indirectly through mutual funds is at risk because of the uncertain nature of equity markets and it becomes difficult for mutual fund investor to time the market and book valueable profits.

Tax Implication: There is no long term capital gain tax on mutual funds, but any mutual funds units encashed within one year of purchase are subject to 15% short term capital gain tax.

When to choose dividend Option?

If you are looking to retire anytime soon and already retired or you need cash at regular intervals, then dividend payout option can work well in your case. This usually happens when you have too many dependent members in your family and any extra penny coming in the form of dividend help you to manage your finances better.

Tax Implications: Dividend earned from mutual funds are not taxable in the hands of investor but there is a dividend distribution tax which is taxable in the hands of mutual fund house.

Conclusion – Dividend Funds or Growth?

After looking at Abhishek’s age, Abhishek may choose a growth option of mutual funds as he is still in the wealth accumulation process and growth option would help him taking advantage of compounding effect and help him building corpus for his retirement needs and other financial goals.

Apart from the return on investment on mutual funds through different methods such as, growth, dividend payout or reivestment, it is important to consider the tax impact of making your choice.  In other words, the ‘post-tax returns’ will differ. This is so because the tax treatment is different for long term and short term holding period.

Hence, in case of equity mutual fund schemes it makes no difference whether you opt for the growth or dividend funds option—as both dividends and long term capital gains from equity funds are tax free!!

About the Author

Vaibhav Sangli is an MBA Finance who loves to write on several topics including insurance and mutual funds and finding out different ways to earn and spend money.

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