While choosing a mutual fund, an investor requires to make a range of choices. Among them, the most puzzling decisions are the ones relating to choosing between growth option or dividend option.
These options relate to how the fund needs to deal with the gains made by the fund over a period of time.
Each option has got its own set of advantages and disadvantages. Investor needs to make a choice based on their personal financial goals and needs. However, once the investor gains clarity on these aspects, making a choice will seem breezy.
Before moving to an analytical mode, let’s have an understanding of these options.
Purpose of having different options
The NAV of the dividend option of a mutual fund scheme might be different from that of a growth option. In fact, in most of the cases, NAV of growth option is found to be higher than dividend option.
Investors might wonder if the schemes are different or same? Actually, the scheme is same and difference in NAVs is due to compounding effect.
In both options, scheme invests in identical securities but the manner of distribution of profit varies. The investment objective, holdings, performance and fund manager remains the same. Only the manner of delivering returns changes.
In case of a dividend option, profits made by the scheme are not re-invested in the scheme. Instead, gains will be distributed among the investors by way of dividends; on a quarterly, half-yearly or annual basis.
However, the fund doesn’t guarantee as regards the amount and frequency of dividend payment. Usually, the fund manager declares the dividend only when the scheme generates profits.
Dividends are paid by redeeming equivalent units of the scheme. Suppose you invest Rs 10 in an equity fund. The NAV of the fund increases to Rs 15 and the fund manager declares a dividend of Rs 2. After payment of dividend, the NAV of the fund falls to Rs 13.
You may perceive the growth option like a cumulative option. The profits made by the scheme are not paid by way of dividend. Instead, these get accumulated and form part of the scheme via reinvestment.
So, whenever the scheme makes a profit, its NAV rises automatically. Conversely, when the scheme suffers a loss, the NAV falls. The only way to get back profits is to sell units of the scheme.
Suppose you buy 100 units of an equity fund at an NAV of Rs 40. Under the growth option, the NAV of the scheme rises to Rs 50 in one year. You sell the units and receive a sum of Rs 5000. Hence, your profits from investment is Rs 1000 (Rs 5000-Rs 4000).
Suitability of dividend and growth option
Whether to go for dividend option or growth option entirely depends on your needs.
Dividend option works best when markets are at all time high. As the NAV of the fund rises consistently, the likelihood of fund declaring dividends is higher.
Moreover, if you are dependent on your investments for a regular income, dividend option might work for you. However, you may lose on compounding of returns aspect as dividends won’t be re-invested in the scheme. Wealth accumulation may slow down as compared to growth option.
Growth option can be suitable for investors having a long-term investment horizon. It will help them in accumulating corpus for retirement. Moreover, in case you earn a regular income and aren’t in need of dividends, go for growth option.
Both of the options will have different tax treatment.
In the recent budget 2018, a dividend distribution tax (DDT) at the rate of 10% has been proposed on equity-oriented mutual funds. The dividend will not be taxed in the hands of investors. However, the DDT might reduce their return on equity funds.
As regards growth option, long-term capital gains over Rs 1 lakh on equity funds will be taxed at the rate of 10%.
How to switch from dividend to growth option
It is possible to switch from dividend option to growth option or vice-versa. It would entail sale of old units and purchase of new units. This might attract exit loads along with tax on capital gains.
Before you switch from one option to another, check for both of these aspects.