Growth vs Dividend mutual fund

You will be presented with lot of options when choosing a mutual fund. Deciding on a mutual fund is difficult and when you have to choose from these many confusing options you tend to run away.

What is Growth mutual fund plan

Growth mutual fund option is the option where you do not receive any amount after investing until you redeem ie when selling the fund.

Assume Mr. Rakesh buys HDFC Equity Fund for Rs 10 lakhs in 2010. Each NAV unit for Rs 1000. You would have got 1000 units. Now in 2019 when you sell , each unit is Rs 2500.

The total value of your portfolio is Rs 25 lakh (1000*2500). He will get Rs 25 lakh today during sell transaction. There would not have been any amount received by you during 2010 to 2019. All dividends from stock held, interest (if any) will everything be added to the NAV for final payout in 2019.

Growth mutual fund is fairly simple and straight forward approach to investing in mutual funds. Not much complication.

What is Dividend mutual Fund plan

Dividend mutual fund option is where you may get periodic payments from the fund from 2019 to 2019 period if you consider example. Assume in March 2013 the fund gets more profit and declared Rs 100 as dividend (post DDT) and NAV was Rs 1500 on 31 March 2013.

After declaring dividend, on 01st April 2013, the mutual fund NAV would adjust to Rs 1400 approximately. Rakesh will get Rs 100 in his bank account per unit.

Types of Dividend mutual fund

Dividend Payout Option – Here the entire dividend of Rs 100 per unit comes to you bank account when dividend is declared/paid by mutual fund.
Dividend Reinvestment Option – In Dividend reinvestment option, the value of Rs 100 per unit does not reach your bank account but is used to purchase more units of same fund which gave you the dividend.In above case, you must have received Rs 100000 as dividend (ie., 1000 units * Rs 100 dividend per unit). This 1,00,000 will be used to buy additional units ie., Rs 100000/1400 = 71.4 units. On 01 April 2013, Mr. Rakesh will now hold 1071.4 units. No money credited to bank.
Dividend Sweep option – In Dividend Sweep option, the Rs 1,00,000 dividend will be used to buy units from another funds of same fund house at prevailing NAV. So as per your direction, they may buy units in HDFC Prudence or HDFC Liquid fund for this Rs 1 lakh. No money/dividend received in bank account.

Common misconception in Dividend mutual funds

When mutual funds are sold with dividend option, there is rampant mis-selling sometimes by advisors. Let us see some cases.

Myth#1: You will get dividends every year – No , there is no guarantee that you will get every year. Advisors use this lie to sell to especially old people who look for regular income. People think these are alternatives to fixed deposits and invest. Don’t do that. There are no guarantees that dividend will be declared every year.
Myth#2: Dividends are free income – Investors assume dividends are free income like they get from stocks. On the contrary, the value of your NAV will come down proportionately to the dividend declared.If a fund declared dividend of Rs 100 and its NAV was Rs 1500 before dividend , then after dividend the NAV will get adjusted to Rs 1400. So dividends from mutual funds are not free or extra income.
Myth#3: Dividends are from profit of mutual funds only – There is no guarantee that dividends are given from profits of mutual funds. Even loss making mutual funds declare dividends and these are paid from your capital. Remove the concept from your mind that if a fund pays you dividend then it is paying from the profit it earned last year. May not be the case.
Myth#4: Dividends from mutual funds don’t have tax – We will see this in bit more details later. But know that funds pay a tax of 11.64% on the dividend provided to you as Dividend Distribution Tax (DDT) with surcharge+cess. Though you’re not taxed directly, you’re paying indirect taxes on dividend.

Which is better – Growth option or Dividend Option in mutual fund

Let us take a small example and find out which wins the battle of Growth vs Dividend mutual fund. Look at the returns below.

From the above image, you see the total returns from an investment of Rs 100000 (one lakh) provides a dividend of Rs 3 lakh over an entire investment period of 30 years.

Here the assumption is 10% per annum and the dividend is paid out at end of every year. Your principal of Rs 1 lakh is also intact. So in total, you’ll receive Rs 4 lakh after 30 years.

You can see that every year you withdraw the returns and hence there is no chance for the money to compound or grow for you.

Now consider the Growth mutual fund. Same assumption of 10% returns per year but instead of withdrawing the returns, they stay invested. Below is how the returns have panned out over 30 years.

You can see clearly the end returns have a mammoth difference between Growth vs Dividend option. The corpus from Growth option is close to Rs 17.5 lakh whereas the corpus from Dividend option is Rs 4 lakh. The final corpus of Growth option is close to 4 times higher than dividend option.

Compounding can work magic for you of you’re patient and you can see the result for yourself in the Growth mutual fund where money is allowed to compound.

We cannot make a blanket statement – as some people especially above 60 years may prefer liquidity over growth. However, in our opinion, the Growth Option always surpasses the Dividend option in long term.

The difference may not be so stark if you’re considering debt funds but still even here Growth option is likely to outperform.

Tax on Growth vs Dividend plan in mutual funds

Growth mutual funds have only long term or short term capital gains which is 10% for long term capital gains (above Rs 1 lakh) and 15% for short term capital gains.

Dividend option of Debt mutual funds have a Dividend Distribution Tax(DDT) of 29.3% including surcharge and cess.

Dividend option of Equity mutual funds have a Dividend Distribution Tax of approx. 11.4% including surcharge and cess. Long Term Capital Gains from debt mutual funds is 20% with indexation benefits. Short Term Gains on debt mutual funds is taxed at slab rate of investors.

In both cases, the dividends are not taxable in hands of the investor. But the investor must keep in mind that DDT has already been paid by the fund manager prior to disbursement.

What to do if you want regular income from mutual funds?

A better option would be to use SWP or Systematic Withdrawal Plan. In this method you periodically sell some units to meet you cash flow needs.

You need to keep in mind that the rate of withdrawal is lesser than the returns generated from your investment per year. This is to ensure you do not deplete your principal and run out of capital after few years.

SWP also provides you with guaranteed income which is absent in Dividend option (as we said before there is no guarantee you will receive dividends every year). So it is better to make systematic withdrawals than choosing dividend mutual fund.

It is our firm belief that there are much better ways for people who want regular income from mutual funds. Dividend option in mutual fund is not the ideal way to receive income.

In the Growth vs Dividend mutual fund battle it is the Growth fund which wins by big margin. It also saves tax and provides better returns. What is your opinion of Growth vs Dividend mutual fund debate and do you agree with us? Comment and let us know if you have any investments in Dividend mutual funds?

Comments

Sridhar ss says

June 3, 2020 at 1:59 am

First of all, a big thanks for your frank & honest way of explaining the facts of investment plans. That inspired me to write this thank you so much once again.
My question is can you suggest a risk free and moderately good return plan , my age is 57 with lot of responsibilities in family. I request a safest way for the principle be suggested. Thank you so much.

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