Growth v/s Dividend MFs: Which is better?

Markets have corrected 10-12 per cent from the peak now, thanks to the geopolitical tensions & inflation.

For investors waiting on the sidelines & having an investment horizon of 3 to 5 years, this correction can be used to invest a lump-sum amount in equity mutual funds. The mutual funds industry itself has grown exponentially in the last decade or so attracting new investors every month as reflected in the growing number of folios.

The Assets Under Management (AUM) of the mutual fund (MF) industry has grown more than fivefold from a mere Rs 7 lakh crores in 2010 to Rs 38 lakh crores today. An investor can invest either a lump-sum amount or take the Systematic Investment Plan (SIP) route. When investing in mutual funds you may be wondering which option to choose: Growth or dividend? You might have asked yourself the question as to which option is better. The option you tick in the box will decide your future cash flows, income accruals, taxability, and the number, and value of units.

Do remember the portfolio that the fund manager manages is the same under both options. To help you decide about these options, here’s a low-down on the two options that mutual funds offer investors.

Also read: The when and how of retirement planning

Growth option

As the name suggests, NAV (net asset value or price per unit) grows along with the appreciation in the portfolio value as profits are reinvested in the scheme. You don’t receive any payouts whenever the fund declares dividends. If you need money you have to redeem either in part or all units. This is also the default option when you don’t tick either the growth or the dividend option at the time of investment. The growth option is ideal for those who don’t depend on regular income streams but instead want to create a corpus for a long-term goal like a retirement fund.

Dividend option (renamed as income distribution cum withdrawal plan)

Under this option, dividends are paid out to investors periodically which could be daily, monthly, half-yearly et cetera. The nomenclature of the dividend option was changed by the Securities and Exchange Board of India (SEBI) to ‘Income Distribution cum Capital Withdrawal Plan’ or IDCW Plans in April 2021.

SEBI must have felt that the use of the word “dividends” was misleading. However, since the payment of dividends or distribution of income is a function of the distributable surplus, there is no guarantee that you will get dividends regularly. It should be used by individuals like retired persons looking for regular income from their investments. Since the dividends are paid out of the profits of the scheme, the NAV will fall to the extent of dividends declared. This NAV, post the distribution of income, is called ex-dividend. If an investor has 1,000 units of a scheme & if the fund has declared a dividend of Rs 4 per unit, he/she will get Rs 4,000. So, as more dividends are paid out from time to time, the difference in the NAV between the two options will keep increasing.

Dividend reinvestment option

Under the IDCW option, you have another option called as reinvestment option. It is similar to the growth option in terms of value. The only difference is whenever the dividend is declared, additional units are allotted and added to your folio. It increases the number of units you hold for the same cost price. While in a dividend payout option, the investor receives the dividend in his bank account and the NAV goes down to reflect the dividend paid out, it does not change the number of units held by the investor.

Which option is better?

Prior to FY 2019-20, dividends were tax-free in the hands of investors. This was scrapped in Budget 2020 and dividends are now added to the income of the individual & taxed as per his tax slabs. It would make sense for you now to opt for the Growth option if you are in the 10/20/30 per cent tax slab. You should opt for the dividend option only if your total taxable income is less than Rs 5 lakhs since you can claim a maximum rebate of Rs 12,500 under Section 87A, making the dividends tax-free in your hands.

(The writer is a CFA, former banker and currently teaches at Manipal Academy of BFSI, Bengaluru)