While selecting a mutual fund, investors have to make a selection based on endless number of choices. Among the more confusing decisions to be made is the choice between a fund with a growth option and a fund with a dividend reinvestment option.
Each type of fund has its advantages and disadvantages, and deciding which is a better fit will depend on your individual needs and circumstances as an investor.
No single mutual fund is perfect for every investor; that’s why there are so many out there with so many different options. When investing in a mutual fund, it’s best to examine all of the particulars of the fund, to avoid investing in a fund that doesn’t suit your individual requirements for growth or cash payout.
In the growth option of a mutual fund scheme, all profits made by the fund are ploughed back into the scheme. Hence, the NAV increases over time compounding your principal. This is similar to the cumulative option in a bank fixed deposit where interest is put back into the fixed deposit account that then sees an exponential growth over a period in time. As an investor, you will have to redeem the units in the fund to realise the growth in the value of the investments.
Investments made under the growth option will not yield any short term income, in the sense that all money invested will continue to be invested until redeemed – i.e. this will give you capital appreciation and hence returns, but not regular (e.g. Monthly) income. For example, if you purchased 1,000 units of a mutual fund at Rs. 11 and sold it a year later at Rs. 15, this difference of Rs. 4,000 (i.e. Rs. 15 – 11 = Rs. 4 * 1,000 units = Rs. 4,000) is your capital gain and returns on investment.
This type of investment is more suited for long term investing in equity mutual funds, as there are no taxes on long term capital gains. Also, equity mutual funds are prone to short term risk, but in the long term they typically give good returns. This option benefits from the power of compounding since not only is the principal invested, but also the notional profit. It is a good option for those who do not need to depend on a monthly income from their investments for their living.
Also, since the fund does not pay out any dividends the NAV is much higher than that of the dividend option for the same fund – however it is to be noted that this difference is only due to the payment of dividends and not due to a substantial variation in the fund performance.
In the dividend option of a mutual fund scheme, the profits made by the fund are distributed to the unit holders from time to time. Dividend option should be chosen if there is an expectation of periodic income from your investment without actually redeeming any of the units.
As an investor, you must remember that the Net Asset Value (NAV) of the fund always reduces by the dividend amount paid out to the investors and that any repurchase after the dividend payout date is made at the ex-dividend NAV.
Dividends from equity mutual funds are tax free in the hands of the investor.
It is important to keep in mind that dividends are not guaranteed, and also that sometimes no dividend is declared throughout the year, if the performance of the fund or markets do not warrant the same
In Debt funds, the AMC deducts a dividend distribution tax (DDT) on behalf of the investor and then pays the dividend to the investor. Therefore, the dividend option in debt funds is not recommended.
DIVIDEND RE INVESTMENT OPTION
This option tries to make the best of both worlds, in the form of declaring dividends to investors, but not issuing the dividends in the form of cash but re-investing the dividends into the same mutual fund for additionalunits. For ELSS Schemes, the new units will be subject to a 3 year lock in. The growth option is a better bet than the dividend reinvestment option.
The choice between these 3 options should primarily be driven by your cash flow requirements. If you do not have any periodic liquidity needs, you may choose the growth option. The returns in the growth option will be reflected in the movement of the scheme’s NAV. On the contrary, if you need regular cash flows from your investments, then choose the dividend option.