Most mutual funds provide multiple options to investor to choose from – Growth, Dividend and Dividend Re-investment. In this article we will look into difference between these options and when to choose one over another.
Growth:
In growth option, NAV (Net Asset Value) reflects the profit or loss made by the fund at any given point of time. When fund makes profit NAV goes up while at loss NAV goes down. Thus over a period of time if fund makes profit NAV keeps increasing. Only way of realizing profit in this option is to sell units of the fund.
Tax implication of equity oriented MF schemes is similar to shares - there is no long term capital gains tax (holding period is more than 1 year), and the short term capital gains tax is 15% (holding period is less than 1 year).
Tax implication of equity oriented MF schemes is similar to shares - there is no long term capital gains tax (holding period is more than 1 year), and the short term capital gains tax is 15% (holding period is less than 1 year).
Dividend
In this option a part of profit made is paid back to the investor in the form of dividend from time to time. The amount and frequency of dividend paid depends on the profit made by the fund and is at the discretion of the fund manager. Thus dividend payment is not guaranteed. Moreover, dividends are paid out from the asset of the fund. Whenever dividend is paid, NAV of the fund goes down proportionately. That why NAV of dividend mutual funds are less than that of their counterpart with growth option. Example – For HDFC Top 200 fund latest (31 Dec 09) NAV for Growth and Dividend options are 180.46 and 46.67 respectively.
In this option a part of profit made is paid back to the investor in the form of dividend from time to time. The amount and frequency of dividend paid depends on the profit made by the fund and is at the discretion of the fund manager. Thus dividend payment is not guaranteed. Moreover, dividends are paid out from the asset of the fund. Whenever dividend is paid, NAV of the fund goes down proportionately. That why NAV of dividend mutual funds are less than that of their counterpart with growth option. Example – For HDFC Top 200 fund latest (31 Dec 09) NAV for Growth and Dividend options are 180.46 and 46.67 respectively.
One key point to note is that dividend paid by mutual funds is “return of capital” and not “return on capital”. This is quite different from the dividend received in stocks. For example, an investor holds some stocks of Reliance and the company declares dividend. In this case dividend is paid from the profit made by Reliance, money gets transferred from Reliance to the investor. However, CMP (Current Market Price) of Reliance stock remains same. Thus the dividend received by the investor is over and above the money that he can realize by selling Reliance stock. But in case of mutual fund, dividend is paid from the fund asset i.e investor’s money is paid back to the investor. This confusion is often misused by many distributors to sell funds to investors.
Dividends are not taxable in the hands of the investors.
Dividend option is relevant if liquidity is required in form of dividend amount. Food for thought – if liquidity is required in short term should you be investing in equity at all? Beyond one year liquidity can be achieved in growth option by selling fund units without any tax.
Dividend Re-investment
This is a variant of Dividend option, wherein dividend is paid in form of units of the same fund. Thus dividend that was supposed to be paid to investor is used to buy units and is credited to his account.
This is a variant of Dividend option, wherein dividend is paid in form of units of the same fund. Thus dividend that was supposed to be paid to investor is used to buy units and is credited to his account.
For all practical purpose Dividend re-investment is same as growth option. So why have this separate option? For historical reason. Earlier, capital gains were taxed at 20% (for long term) and 30%( for short term). While dividends were taxed much less. Since growth option funds had only capital gains anytime units are sold for liquidity tax liability was more. To offset this dividend re-investment was introduced to ensure that dividends paid lesser tax and re-investment, being usually at a higher NAV as fund is growing, will attract less capital gains tax when sold.
With current tax structure dividend re-investment is not relevant. Thus for all practical purpose this option can be ignored unless there is any change in tax structure in future.
Illustration
Following table explains implications of investing same amount with different options:
Key takeaway
- In growth option, fund NAV keeps increasing with profit. In dividend option a part of the profit is paid back to the investor in cash or kind (extra units in case of dividend re-investment).
- Dividend in case of mutual fund is a misnomer. It’s “return of capital” and not “return on capital”. Dividend is paid from fund asset which reduces NAV. So be wary of distributors who try selling mutual funds based on dividend.
- Tax implication of all three options is same if holding period is more than 1 year.
- Growth is best option for long term investors.
- Dividend options provide liquidity in form of dividend amount. But if liquidity in short term is a concern for an investor, equity might not be the right choice in the first place. More so, because mutual fund dividend is not guaranteed.
- Dividend re-investment is not relevant with current tax structure and can be ignored.
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This is a very good post it explains how people have different views on mutual funds but according to me it is beneficial .
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Very clear post about Indian mutual funds investment. I enjoyed reading the post!
ReplyDeleteWonderful post about mutual funds!
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