Mutual fund investments have usually two options: dividend and growth. The amount invested by you in mutual funds are used to buy stocks, bonds or other investments. Over the period of time, the value of investments and cash surplus held in a mutual fund scheme is reflected in its NAV (Net Asset Value).
The mutual fund scheme in which you have invested makes profits on selling some of these investments that has appreciated based on stock price movements. Over time, these provide cash inflow for the mutual fund that it can either choose to re-invest by making fresh investments (growth option) or payout as dividend to unit holders (dividend option).
Say, a new Equity mutual fund scheme was launched a year back and collected money from investors at Rs. 10 NAV under two options — dividend and growth. Today, the NAV of both the growth option and dividend option is Rs. 18. The fund manager decides to book profits in investments and share the same with its unit holders who have opted for dividend. So he announces 50 per cent dividend. i.e. Rs 5/- per unit.
If this mutual fund advertises this dividend announcement by quoting a future record date for attracting more investments, is it prudent to invest for getting the dividend at the time of investment itself?
Unfortunately, the answer for this question is No. The next day after the dividend record date, the NAV of this investment would drop to Rs. 13/-.
This is because a dividend from a mutual fund is nothing but a return of capital held by the fund scheme. The Rs. 18 NAV of the scheme with the dividend option, already included the distributable cash of Rs. 5/-, on distribution of which, as logic would suggest, the NAV reduced by an equal amount. Nothing is free in this world!
The NAV of the scheme with the growth option would remain at Rs. 18/- because the scheme didn’t distribute a dividend. An investor is no better off choosing the dividend option instead of the growth option. And, his purchase decision, triggered purely by the lure of quick returns through the dividend, is a misinformed one.
Every time a fund scheme announces a dividend, the same scenario will repeat, i.e. the NAV of the scheme will drop by an amount equal to the dividend amount. Within the same scheme, the NAV of the growth option will always be higher than that of the dividend option because the money is going back into the scheme and not given to investors. The reason for the difference in NAV between these two identically managed plans is that one keeps stripping money and dispatching it to investors while the other just re-invests any gains (income). It is this re-investment that has accumulated and appreciated over time, resulting in a much higher NAV today — a substantial capital gain.
So, Investors who only need long-term capital gain (wealth appreciation preferred over income) can choose the growth option. Such investors can still pay themselves a dividend when they want liquidity or when they feel the market is overvalued, by simply selling the requisite number of units!
On the other hand, investors who need income can choose the dividend option. The dividend amount should not be the sole deciding factor while investing, because technically a fund can declare high dividends by merely selling its assets, irrespective of whether it has made a profit or loss! So dividends need to be evaluated in conjunction with the total returns that the fund has been able to generate.
However, investment in the mutual funds with dividend option would be beneficial in two aspects. One is the tax treatment.
The following table illustrates the tax implications of dividends compared to capital gains. If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends.
On the other hand if your holding period is less than a year, then you have to pay more short term capital gains tax as the amount equivalent to the dividend that was distributed in respect of mutual fund with dividend option,would be part of Net asset value in the case of growth option which is also taxable
The other is the benefit of tax exemption under Section 80C of IT act for the full amount invested in ELSS mutual fund with dividend option (Equity linked Savings Scheme) and yet getting back a portion of amount as dividend which would reduce your investment that is locked for 3 years (note : ELSS funds have three year compulsory locking period)