Growth Vs Dividend options of Mutual Funds

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Last weekend I met two of my friends for dinner, and we were talking about mutual funds. They both had invested in ABC Mutual Fund and were arguing on the NAV of the fund. One claimed that it was Rs. 35, while the other was certain it was Rs. 50. I checked and confirmed that they were both correct. They were stumped as to how one fund can have two NAVs. I explained that both of them had bought different schemes of the same fund. One had purchased the growth option and other had purchased the dividend option.

Meaning:
A mutual fund generally has two schemes - growth and dividend. In a growth scheme, the profits made by the fund are invested back into the fund and are not distributed to the unit holders. A dividend scheme, on the other hand, periodically distributes its profits to the unit holders in the form of dividends.

Effect on NAV under both the schemes:
Suppose you invested Rs. 10,000 each in growth and dividend schemes of XYZ equity mutual fund.
NAV of both the schemes: Rs. 100
Number of units held: 100
Face value: Rs.10
Returns from both the schemes: 50% at the end of Year 1
The dividend scheme declares a dividend of 20%, ie: Rs.20 per unit
NAV of the growth scheme grows to Rs. 150 (Rs.100+ 50% returns). Your investment is worth Rs.15,000.
Under the dividend scheme, you get a dividend of Rs. 2,000 (Rs. 20*100). Now NAV will fall by Rs. 20 which has been paid out as dividend. NAV after dividend payout will be: Rs. 100+Rs.50 Rs.20=Rs.130. Your investment is now worth Rs. 13,000 (Rs.130*100 units). In addition, you have received Rs. 2,000 as dividend. So the total worth of your investment is Rs. 15,000 under the dividend scheme as well.
The NAV of the growth scheme will always be higher than its dividend counterpart due to this adjustment.

How does this impact you as an investor?
As an investor, you can see from the above example that your total returns are same in both the cases after Year 1. However, over a long term, the growth scheme benefits from compounding effect on the returns re-invested, and give a higher return compared to the dividend scheme.

Tax Treatment:
Equity Funds: Dividends from equity funds also do not attract Dividend Distribution Tax (DDT). Thus, for a short term investor in equity funds, dividend schemes are better, as dividend is tax free, and the short term capital gain is lower due to a fall in NAV. For long term investors, it makes no difference if you opt for growth or dividend schemes, as both dividends and long term capital gains are tax free.

Debt Funds: Debt funds attract DDT of 13.52%, which is deducted before releasing dividend to the investors. A short term investor with a high tax bracket can opt for dividend schemes, as short term capital gains is as per the income bracket and can work out to be higher than DDT. However, a long term investor can choose growth schemes to lower tax outflow by claiming benefits of indexation on long term capital gains.

Which scheme is better?
As returns from both the schemes are almost the same, the choice depends on your needs and the market situation. However, do keep in mind that the frequency and amount of dividends are not guaranteed. It is solely at the discretion of the fund. If you are looking at regular cash flows, then dividend schemes work best for you. On the other hand, if you are a long term investor and are not interested in regular cash inflows, you can opt for the growth option.

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