Picking a mutual fund and investing in it is essentially about making an endless number of choices, especially in a market like India where there are hundreds of fund schemes to choose from. But do you consider which scheme or plan suits you best? Take the case of growth and dividend funds. How many fund investors do seriously consider their investment horizon, cash flows and the tax slab they fall in before choosing a growth or a dividend fund?
Let’s first go into the detail of what a growth and dividend fund means. To put it baldly, mutual fund schemes are broadly categorized into two schemes/plans: growth funds and dividend funds. The latter has one more offshoot known as dividend reinvestment funds. These two broad categories of funds could belong to any class i.e. equity, debt or hybrid, or, for that matter, large-cap, mid-cap and small-cap, etc.
Growth and dividend funds are not meant for all types of fund investors with different investment goals, time frame and having different tax slabs.
A No Brainer
You don’t need to be Professor Henry Higgins of the modern age to understand the difference between growth and dividend funds. When it comes to choosing between the two, the first factor you should understand is their respective investment strategy. Growth funds, as the name suggests, continue to grow your investments and the capital appreciation of your investment is ploughed back into the fund. You as an investor in the fund don’t get any dividend, bonus, etc during the course of the fund’s holding period but only when you redeem the units. As a result of this, the NAV of the fund goes up over a period of time compounding your investment.
Dividend yield or dividend payout funds, on the other hands, are for those investors who look for getting regular payouts in the form of dividends as well as capital appreciation. However, the dividends are not guaranteed and declaration of dividend is discretion of the fund management. Such funds invest in companies that have a long history of paying dividends and have strong cash flows, both large cap as well as mid cap companies. So if the companies do well the fund’s gains rises that is distributed to investors in the form of dividends from time to time.
Dividend funds are more apt for investors with a moderate risk appetite. This is because they are equipped to limit downside risks and protect capital during equity market turmoil as they invest in stable companies having sound fundamentals and have low portfolio churning and low standard deviation.
“In the case of funds investing into high-dividend yield stocks, the risk is slightly lower than growth stocks as high dividend-paying stocks are usually blue-chips and mostly engaged into IT and allied sectors and banks. The downside risk here is lower when compared to growth stocks but so is the upside potential,” maintains Rakesh Goyal, Senior Vice President, Bonanza Portfolio.
Not A Hobson’s Choice
The NAV of dividend-paying funds are in most cases lower than that of growth funds, simply because the returns are taken out of the fund’s corpus and paid to investors. However, this is also a major factor behind the myth a lot of investors harbor surrounding growth and dividend funds i.e. both are different funds in terms of yield. In reality, however the return of both the funds is identical (See Choosing...).
“All the funds [growth, dividend payout] primarily have given identical returns in terms of performance. The post tax return would have been different considering the horizon for which funds have been invested,” says Gajendra Kothari, MD & CEO, Etica Wealth Management.
When a dividend is declared by a fund, it is declared on the face value of the fund. The dividend is skimmed off the NAV of the fund and then paid out to you as an investor. Hence the NAV declines in proportionate to the quantum of dividends paid out in a given period. If a fund, for instance, has an NAV of Rs 100 and the fund declares a 20% dividend, this means a dividend of Rs two on the fund’s face value of Rs 10 per unit held. As a result, the NAV of the fund will go down by Rs two to Rs 98 after paying the dividend.
As Goyal argues, “Difference in NAV may occur due to mark-to-market losses/gains on portfolios, management expenses and dividend payouts, cash positions and various other factors. Thus, we cannot compare the NAV of one fund with the other and say which is better on the valuation front.”
“Unlike a stock where the entry price matters, NAV is just a mere number that has no relations to the yield. Whether you choose a dividend option or growth option the returns will be the same,” adds Kripananda Chidambaram, Director, Fintotal Advisory and Consulting that runs a personal finance portal fintotal.com.
Experts argue that when it comes to choosing between growth and dividend funds, investors should weigh their risk taking capacity, investment tenure and tax considerations.
If you as an investor are looking for long-term capital appreciation and don’t have periodic cash flow needs, it’s better to go for growth option in equity funds, simply because the power of compounding works in favour of you in the long term. On the other hand, if you need regular cash flow from your investments, you could opt for dividend options.
Secondly, when it comes to choosing between equity (growth or dividend) and debt (growth or dividend) you should consider your investment horizon.
“For equity mutual funds, the best bet would be growth option. This is because you can make compounding work for you. If you receive regular dividends, you may end up using that money for non-priority things. Wealth per se is created only if you let it compound,” says Chidambaram.
Your tax outgo should also be a factor while picking a growth or a dividend option. Your tax liability on growth option, for instance, depends on the holding period. The long term capital gains (when holding period is more than 1 year) on equity mutual funds is zero while that short term capital gains (when holding period is less than 1 year) is 15%.
In case of debt funds, if you sell them before one year the short term capital gains is clubbed with your income and is taxed according to the tax slab you fall in. The long term capital gains on debt funds is calculated at 10% without indexation and 20% with indexation.
Now, if you want to invest in a debt fund and your investment timeframe is less than one year, you should go for dividend option and growth option if it is more than one year.
“If it is a debt fund and if the horizon is less than 1 year then payout option may be better for a person who is in highest tax bracket (30%). But if the investor has above 1 year horizon, then the growth option is better from taxation point of view as it would be considered as long term capital gain and hence taxation will be low at 10%,” maintains Kothari of Etica Wealth Management.
So if you are planning to invest in a mutual fund, don’t forget to ascertain if it’s a growth fund or a dividend fund.