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This article talks about various options available to Mutual Fund (MF) investors – Growth, Dividend and Dividend Reinvestment. It guides readers about which option is most suitable for them.
We love equity markets, because stocks give the best return in the long run. (Please read “Stocks – The winning bet for the long term” for more details)
We also know that for most of us, investing in shares using mutual funds (MFs) is better than direct investment in shares. (Please read “Direct investment in Stocks versus Mutual Funds (MFs)?” for more details)
But even after you have decided to invest through a mutual fund, and have selected the right scheme, there is a dilemma. Which option do you choose – Growth, Dividend, or Dividend Reinvestment?
Let’s examine each option in detail, so that you can decide which one is the best for you.
Growth Option
In this option, all the profits (and losses) made by the mutual fund scheme are reflected in the NAV of the MF Unit. When a profit is made, the NAV goes up, and when a loss is made, the NAV goes down.
Over time, as the MF scheme makes profits, the NAV of each unit keeps increasing. There is never a distribution of the profits made. The only option to realize the profit in the growth option is to sell some / all the units.
Suitable for
- Want capital appreciation
- Do not want a regular income
- Are long term investors
Income Tax Implications
The tax treatment of equity oriented MF schemes is similar to shares – there is no long term capital gains tax, and the short term capital gains tax is 10% (Changed to 15% from FY2008-09). Since most of you would be wisely investing in stocks only for the long term (much longer than the legal definition of long term – 1 year!), all the profit from units of an MF scheme with a growth option would be tax free.
My Thoughts
As I always stress, only long term investors should invest in stocks. (Please read “Stocks – The winning bet for the long term” for more details) Therefore, the Growth Option is the best option in my opinion, as it gives the best possible returns in the form of capital appreciation in the long term.
Dividend Option
In this option, too, the profits (and losses) made by the mutual fund scheme are reflected in the NAV of the MF Unit. But the big difference is that there is regular distribution of the profits made. This distribution is in the form of dividends declared from time to time.
The amount and frequency of the dividends depends on the profits made by the MF scheme, and is never guaranteed. Dividends are declared only when the MF scheme makes a profit, and it is at the total discretion of the fund manager.
The dividend is paid out from the NAV of the unit. This means that when the dividend is paid out, the NAV of each unit goes down by an equal amount.
For example, if the NAV is Rs. 18, and a dividend of Rs. 1 is paid out, the NAV would immediately go down to Rs. 17.
For this reason, you would see that for the same MF scheme, the NAV of a unit with dividend option is always less than the NAV of a unit with growth option.
Suitable for
- Want regular income stream (although this is not guaranteed)
- Are not very interested in long term capital appreciation
Income Tax Implications
Dividends are not taxable in the hands of the investors. This means that all the income generated in the form of dividends is tax free.
(Thus, in terms of tax treatment, there is effectively no impact on your returns whether you go for growth option or dividend option).
My Thoughts
Although I favour long-term investment in shares, there is one occasion when I think a dividend option can be considered. This is in the case of overheated markets, or markets in which valuations are stretched.
If you are the kind that would get worried when the valuation of the market is very stretched, and would want to book partial profits, dividend option can work for you. This is because the periodic distribution of dividend acts like profit booking – since dividend is paid out from the profit earned, in a way, it is like booking profits by selling some stocks or units. So, even if the market goes down, you would have booked some of the profit.
The good part is that you don’t have to worry about the timing of booking the profit. But the bad part is that you leave it totally in the hands of the fund manager. That’s the tradeoff!
Again, to stress, I would say that only the people who get jittery when markets go too high should consider this. For most of us, growth option is the best option.
Dividend Reinvestment Option
This is a variant of dividend option. Here, the dividend is distributed periodically, but in the form of the units of the same MF scheme.
It goes like this – the amount supposed to be paid out as dividend is used to buy the units of the same MF scheme for you, and these units are credited into your account.
Although the dividend is reinvestment in this option, in effect, this is very similar to the growth option. This is because you still get capital appreciation – but in the form of increase in the number of units of the scheme.
In growth option, you have less number of units with a higher NAV. In contrast, in this option, you have more number of units, but with a lower NAV.
Income Tax Implications
Same as dividend distribution option.
My thoughts
I do not see any particular advantage of this option.
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[Comment by - Hari Prasad]
As there are thousands of MF schems available in the market. Evry AMC has similar schemes with diffrent name but same objective and similar investment strategies.. In such a situation, it becomes very difficult to choose right scheme under specifi segment (like equity diversified, Large cap, Mid cap, Sectoral, ELSS, etc.,)
I also understand there are several paraameters to evaluate different mutual funds like sharp ratio, Mean Deviation, %returns, expense ratio, fund house credibility etc., etc.,
Could u pl explain in breif a step by step procedure for an individual to select an appropriate MF scheme beffore deciding to put in his hard earned money.
Thank u.
Hari Prasad
Bangalore
hello sir- as per the budget 08-09 isnt the STCG taxed at 15 % (excluding surcharge & education cess)?
also i understand that in case of debt MF there is a dividend distribution tax. can you please let me know the details of the same & rates as per the latest budget ie FY 08-09?
thanks for your response
Dear Venkat,
Thanks for pointing this out. You are right – budget 08-09 changed the short term capital gains tax rate from 10% to 15%. Since this article was written before the budget, it mentions 10%. I would update the article accordingly.
Yes, MFs do have to pay a dividend distribution tax (DDT). Currently, FMPs have to pay a DDT of 12.5%.
I am confused between choosing the Dividend (with reinvest) option vs Growth option.
I think the DDT reduces the number of units I would get with the dividend with reinvest – hence providing better capital appreciation if I go with growth option. Please advice.
Also, does a Equity fund have to pay DDT?
Thank you.